Everything you need to know about: Alternate Investment Funds (AIFs)

Written By:
April 3, 2024
Everything you need to know about: Alternate Investment Funds (AIFs)

What are Alternative Investment Funds (AIFs)?

Alternative Investment Funds (AIFs) are privately pooled investment vehicles that invest in alternative asset classes, such as private equity, hedge funds, real estate, commodities, and derivatives. AIFs are designed for high-net-worth individuals, family offices, and institutional investors, and they are regulated by the Securities and Exchange Board of India (SEBI).

AIFs offer a more comprehensive range of investment opportunities and alternative asset management methods, often generating higher returns with lower correlation to traditional investments. They can be structured as trusts, limited liability partnerships (LLPs), or companies, and are subject to different regulations than mutual funds.

Types of Alternate Investment Funds (AIFs)

There are three categories of Alternate Investment Funds (AIFs):

1. Category 1 AIF

Category 1 AIFs invest in small and medium enterprises (SMEs), start-ups, and new economically viable businesses with high growth potential. These funds play a crucial role in supporting the growth of the entrepreneurial ecosystem.

Category 1 AIFs include: funds that invest in early-stage technology companies, venture capital funds, infrastructure funds, and angel investor funds.

2. Category 2 AIF

Category 2 AIFs include funds that do not fall under Category 1 or Category 3, and do not employ leverage or borrowing other than for daily operational needs, as permitted by SEBI.

Category 2 AIFs include: private equity funds, debt funds, and fund of funds.

3. Category 3 AIF

Category 3 AIFs employ diverse or complex trading strategies and may use leverage. These funds are considered to have a higher risk profile compared to Category 1 and Category 2 AIFs.

Category 3 AIFs include: hedge funds, Private Investment in Public Equity Fund (PIPE), and commodity funds.  

Why Invest in Alternate Investment Funds (AIFs)?

Investing in AIFs offers several potential opportunities:

1. Diversification opportunities

AIFs provide access to alternative asset classes such as private equity, real estate, and hedge funds. Investors can reduce risk and potentially enhance returns by diversifying their portfolios.  

2. Higher returns compared to traditional investment options

AIFs have the potential to generate higher returns due to their exposure to alternative asset classes and specialized investment strategies.

3. Access to specialized investment strategies

AIFs often employ sophisticated investment strategies that are not available to retail investors. These strategies may include private equity investments, distressed asset purchases, and derivatives trading.

How are Alternate Investment Funds (AIFs) Taxed?

AIF taxation depends on the type of category of AIFs invested in.  

Category I AIFs, which invest in start-ups, SMEs, and other socially relevant areas, are eligible for tax pass-through status. This means the income earned by the fund is taxed by the investors at their applicable tax rates.  

Category II AIFs, which invest in real estate, private equity, and other areas, are taxed similarly to Category I AIFs.  

Category III AIFs, which employ complex trading strategies, are taxed differently. The income earned by Category III AIFs is taxed at the fund level, and the investors are taxed on the income distributed to them.  

It is important to note that the taxation of AIFs is complex and depends on various factors, including the type of AIF, the nature of the investments, and the residency status of the investors. Therefore, it is advisable to consult a tax expert before investing in AIFs.

Benefits of Alternate Investment Funds (AIFs)

Investing in AIFs offers several benefits:

1. Flexibility and customization options

AIFs provide investors with flexibility in terms of investment strategies, asset classes, and risk profiles. Investors can choose AIFs that align with their investment objectives and risk tolerance.

2. Access to alternative asset classes

AIFs offer exposure to alternative asset classes such as private equity, real estate, and infrastructure. These asset classes have the potential to generate attractive returns and provide diversification benefits.

3. Professional management and expertise

AIFs are managed by experienced investment professionals who have specialized knowledge in their respective asset classes. This professional management can help investors understand complex investment landscapes and potentially enhance returns.

4. Potential for higher risk-adjusted returns

AIFs, especially those in Category 3, have the potential to generate higher risk-adjusted returns compared to traditional investment options.

Risks related to Alternate Investment Funds (AIFs)

Investing in AIFs comes with certain risks:

1. Market and liquidity risks

AIFs may be exposed to market volatility and liquidity constraints, especially in illiquid asset classes such as real estate and private equity. Investors should be aware of the potential for fluctuations in the value of their investments.

2. Regulatory and compliance risks

AIFs are subject to regulatory oversight, and changes in regulations can impact their operations and investment strategies. Investors should stay informed about regulatory developments and their potential impact on AIFs.

3. Lack of transparency and information asymmetry

AIFs may have limited transparency compared to traditional investment options. Investors may have limited access to information about the underlying investments and the fund's performance.

4. Potential for higher volatility

AIFs, especially those in Category 3, may exhibit higher volatility compared to traditional investment options. Investors should carefully consider their risk tolerance before investing in AIFs.


In conclusion, Alternate Investment Funds (AIFs) offer investors a gateway to a diverse world of investment opportunities beyond traditional avenues. With their categorization into Category I, II, and III, AIFs cater to a wide range of investment preferences and risk appetites.  

From start-ups and SMEs to real estate and complex trading strategies, AIFs provide access to unique asset classes and strategies, promising potentially higher returns for sophisticated investors. However, alongside the allure of higher returns come the complexities of taxation, risks, and regulatory considerations that investors must navigate diligently.

FAQs on Alternate Investment Funds (AIFs)

1. Who can invest in Alternate Investment Funds (AIFs)?

AIF investors must meet eligibility criteria, including residency status (Indian, NRI, or foreign national) and minimum investment limits (Rs. 1 crore for investors, Rs. 25 lakhs for directors, employees, and fund managers). AIFs have a minimum lock-in period of three years, and the number of investors in each scheme is limited to 1000 (except angel funds with up to 49 investors).

2. Are hedge funds alternate investments?

Yes, hedge funds are a type of alternate investment that employs complex trading strategies to generate returns.

3. How to start an Alternate Investment Funds (AIFs)?

Starting an AIF requires registration with SEBI, formulating an investment policy, and raising capital from eligible investors.

4. How many types of Alternate Investment Funds (AIFs) are there?

SEBI has categorized AIFs into three types: Category I, II, and III, based on their investment objectives and strategies.

Related Blogs

No items found.