Table of Contents
Chapter 3: Concepts in the AIF Industry
The operational architecture of an Alternative Investment Fund rests upon a specialized ecosystem of institutional participants, fiduciaries, and service providers. Each entity performs distinct legal, fiduciary, and commercial functions governed by statutory agreements and regulatory charters.
+----------------------------------------------------------------------------------------------------+
| AIF ECOSYSTEM OPERATING ARCHITECTURE |
+----------------------------------------------------------------------------------------------------+
| |
| +-------------------------+ +--------------------------+ |
| | INVESTORS (LPs) | | SPONSOR / GP | |
| | • Ultra-HNIs & Families | | • Commits skin-in-the- | |
| | • Endowments & Pensions | | game capital (2.5%/5%) | |
| +------------+------------+ +------------+-------------+ |
| | | |
| | Contributes Capital | Promotes Fund |
| v v |
| +--------------------------------------------------------------------+ |
| | THE ALTERNATIVE INVESTMENT FUND (TRUST) | |
| | Formed via Indenture of Trust; Legal Ownership held by Trustee | |
| +----------------------------------+---------------------------------+ |
| | |
| Appoints Investment Manager | Managed by |
| v |
| +--------------------------------------------------------------------+ |
| | INVESTMENT MANAGER (AMC) | |
| | • Sourcing, Due Diligence, Investment Committee, Value Creation | |
| +----------------------------------+---------------------------------+ |
| | |
| | Deploys Capital |
| v |
| +--------------------------------------------------------------------+ |
| | PORTFOLIO INVESTEE COMPANIES | |
| | • Startups, Growth Companies, Real Estate SPVs, Private Borrowers | |
| +--------------------------------------------------------------------+ |
+----------------------------------------------------------------------------------------------------+
Core Participants in an AIF
- The Settlor and Trustee: In India, most AIFs are established as contributory irrevocable trusts under the Indian Trusts Act, 1882. The Settlor creates the trust with a nominal settlement amount. The Trustee (an independent, regulated corporate trustee such as Vistra, Beacon, or Catalyst) holds legal title to the fund's assets in a fiduciary capacity for the beneficial interest of the unit-holders (investors).
- The Sponsor: Any person or entity who promotes the AIF, establishes the trust/LLP, and commits mandatory "skin-in-the-game" capital (under SEBI regulations, a minimum of 2.5% of corpus or ₹5 Crore for Cat I/II, whichever is lower) to ensure strict alignment of economic interest with investors.
- The Investment Manager: The operational entity (typically a Private Limited company or LLP) appointed by the Trustee via an Investment Management Agreement (IMA). The Manager is responsible for pipeline deal sourcing, rigorous due diligence, negotiating investment terms, portfolio monitoring, and orchestrating profitable exits.
- The Investors (Limited Partners / Beneficiaries): Accredited institutions, family offices, and HNIs who execute a Contribution Agreement, committing capital to be drawn down over time in exchange for pro-rata beneficial units of the fund.
- Key Intermediaries:
- Custodian: Regulated entity responsible for safekeeping securities, financial assets, and demat accounts (mandatory for all Cat III AIFs, and Cat I/II with corpus > ₹500 Crore).
- Registrar and Transfer Agent (RTA): Maintains the master register of unit-holders, processes capital call notices, reconciles collections, and issues monthly/quarterly unit statements.
- Independent Valuer: Certified entity that periodically computes fair valuation of unlisted portfolio assets in accordance with IPEV or SEBI guidelines.
Unlike traditional mutual funds where 100% of the investment amount is deposited upfront at the time of subscription, closed-ended Alternative Investment Funds operate through a multi-year Committed Capital and Drawdown Architecture.
The Capital Lifecycle Framework
+----------------------------------------------------------------------------------------------------+
| AIF CAPITAL COMMITMENT TIMELINE |
+----------------------------------------------------------------------------------------------------+
| |
| [ FIRST CLOSE ] ===================> [ FINAL CLOSE ] ===============> [ INVESTMENT PERIOD ENDS ]
| • Initial LP commitments • Maximum fund size reached • No fresh platform deals
| • Fund operationalized • Typically 12-18 months post • Only follow-ons & exits
| • Drawdowns begin First Close • Focus on harvesting
| |
| |<----------------- 12 to 18 Months ------------------>|<------------ 3 to 5 Years ------------->|
+----------------------------------------------------------------------------------------------------+
Core Capital Terminology
| Concept | Statutory & Operational Definition | Functional Implication |
|---|---|---|
| Capital Commitment | The total binding legal contractual amount an investor agrees to contribute to the AIF over its life. | Forms the basis for calculating initial management fees and determining voting rights in LP assemblies. |
| Minimum Ticket Size | Statutory minimum commitment mandated by SEBI: ₹1 Crore for standard investors; ₹25 Lakh for employees/directors of the AIF/Manager. | Ensures that only sophisticated, financially capable investors participate. |
| Drawdown / Capital Call | A formal legal notice issued by the Manager requiring the investor to remit a specified percentage of their committed capital. | Typically issued with 10 to 15 business days notice to fund specific approved investments or expenses. |
| Capital Invested | The cumulative drawn-down capital that has been deployed into portfolio companies. | Excludes uncalled commitments and dry powder held in temporary bank deposits or liquid debt. |
| Dry Powder | The uncalled, uninvested portion of the fund's total committed capital. | Represents ready liquidity available for future follow-on rounds or attractive market buying opportunities. |
| Defaulting Investor | An investor who fails to remit the called drawdown amount within the contractual notice period. | Triggers severe punitive remedies: forfeiture of prior distributions, suspension of voting rights, interest penalties (e.g., 18% p.a.), or forced sale of units at a steep discount. |
The economic relationship between the Fund Manager (General Partner / GP) and the Investors (Limited Partners / LPs) is governed by a performance-aligned compensation model traditionally known as the "Two and Twenty" structure, implemented via a strictly sequenced Distribution Waterfall.
1. Management Fees and Fund Expenses
- Management Fee: An annual fee (typically ranging from 1.5% to 2.5% p.a.) charged by the Manager to cover operational overhead, investment team salaries, deal sourcing, and research infrastructure.
- During the Investment Period: Generally calculated as a percentage of Total Committed Capital.
- Post-Investment Period: Steps down to a percentage of Net Invested Capital (excluding realized or written-off investments).
- Operating Expenses: Fund setup costs (capped in the PPM, e.g., at 0.5% of commitments), audit fees, legal and custodial costs, and third-party valuation fees are charged directly to the fund.
2. Hurdle Rate (Preferred Return)
The Hurdle Rate is the minimum annualized internal rate of return (IRR) that the fund must generate and return to investors before the Manager is entitled to share in any profit distributions. In India, hurdle rates typically range between 8% and 12% p.a. (compounded annually), providing investors with a guaranteed preferred return on their drawn-down capital.
3. Carried Interest ("Carry")
Carried interest represents the performance incentive fee paid to the Investment Manager, typically 20% of net profits generated beyond the hurdle rate. Carry aligns the manager's commercial incentives with those of the investors: if the fund underperforms the hurdle rate, the manager receives zero carry.
+----------------------------------------------------------------------------------------------------+
| THE 4-STAGE DISTRIBUTION WATERFALL |
+----------------------------------------------------------------------------------------------------+
| |
| [ STAGE 1: RETURN OF CAPITAL ] |
| 100% of distributable cash proceeds flow to Investors (LPs) until they receive 100% of their |
| cumulative drawn-down capital contributions. |
| | |
| v |
| [ STAGE 2: PREFERRED RETURN (HURDLE) ] |
| 100% of proceeds flow to Investors until they achieve their contractual Hurdle Rate |
| (e.g., 8% to 10% annualized compounded IRR on invested capital). |
| | |
| v |
| [ STAGE 3: GP CATCH-UP ] |
| 100% (or 80%) of subsequent proceeds flow to the Manager (GP) until the Manager has received |
| their contractual profit share (e.g., 20% of the total profits distributed in Stages 2 and 3). |
| | |
| v |
| [ STAGE 4: FINAL PROFIT SPLIT (CARRIED INTEREST) ] |
| All remaining proceeds are split: |
| • 80% to Investors (LPs) |
| • 20% to Investment Manager (GP Carried Interest) |
| |
+----------------------------------------------------------------------------------------------------+
Whole-of-Fund Waterfall (European) vs. Deal-by-Deal Waterfall (American)
- Whole-of-Fund Waterfall (European Style): The standard in India and Europe for closed-ended Cat I and II AIFs. The Manager receives carried interest only after investors have recovered their entire capital across all investments plus the hurdle rate across the whole fund. This strongly protects investors against early-stage false profits.
- Deal-by-Deal Waterfall (American Style): Carry is calculated and distributed on each separate profitable exit as it occurs. To protect investors, American waterfalls incorporate a mandatory Clawback Clause, requiring the manager to return excess carry at fund liquidation if subsequent investments suffer losses that drag overall fund returns below the hurdle rate.