Table of Contents
Chapter 5: Regulatory Framework
The regulatory framework for Category III Alternative Investment Funds in India is anchored in the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012, complemented by operational circulars, master directions, and systemic market integrity norms.
Registration and Statutory Fitness Criteria (Regulation 4)
Any entity seeking to establish a Category III AIF must apply to SEBI in Form A:
- Constitutional Mandate: The constitutional charter (Trust Deed, LLP Agreement, or MOA/AOA) must explicitly prohibit inviting the public to subscribe to its securities.
- Key Personnel Competence: Key investment personnel of the Investment Manager must hold professional qualifications in finance, accountancy, or law and possess at least five years of relevant professional experience in securities management, fund operations, or capital markets.
- Mandatory Continuing Interest (Sponsor Commitment): Under Regulation 10(d), the Sponsor or Manager of a Category III AIF must maintain a continuing economic interest of not less than 5% of the corpus or ₹10 Crore, whichever is lower. This continuing interest must be maintained throughout the life of the scheme and cannot be waived or transferred.
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| CATEGORY III AIF REGULATORY CORE CONDITIONS |
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| REGULATORY PARAMETER | STATUTORY MANDATE & PRESCRIBED LIMIT |
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| Minimum Scheme Corpus | **₹20 Crore** across all schemes. |
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| Minimum Investment Size | **₹1 Crore** for regular investors; **₹25 Lakh** for employees/directors|
| | of the AIF or Investment Manager. |
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| Investor Cap per Scheme | Maximum **1,000 investors** per scheme. |
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| Dematerialization Mandate| All units of Category III AIFs must be issued and held strictly in |
| | **dematerialized (demat)** form with NSDL or CDSL. |
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| Plan Types Mandated | Funds must offer both a **Direct Plan** (no distribution commissions) |
| | and a **Regular Plan** (with distribution commissions disclosed). |
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The Accredited Investor (AI) Framework
Under SEBI Regulations:
- Eligibility Criteria: Individuals with annual income $\ge$ ₹2 Crore, or net worth $\ge$ ₹7.5 Crore (with at least ₹3.75 Crore in financial assets). Corporate entities with net worth $\ge$ ₹50 Crore.
- Large Value Funds for Accredited Investors (LVFs): If every investor in a Category III AIF scheme is an Accredited Investor committing at least ₹70 Crore, the scheme is exempt from standard PPM review filing timelines, enjoys flexibility in bilateral terms, and can negotiate higher leverage limits subject to LP approval.
Because Category III AIFs utilize financial derivatives, short positions, and borrowing, SEBI imposes strict portfolio concentration caps and leverage boundaries to prevent systemic risk.
1. Portfolio Concentration Limits (Regulation 15(1)(d))
- A Category III AIF cannot invest more than 10% of its investible funds in a single investee company.
- Calculation Baseline: For an open-ended Category III AIF, the 10% concentration limit is calculated on the basis of the fund's Net Asset Value (NAV) at the time of making the investment.
2. Comprehensive Leverage Architecture and 2x Exposure Cap
Unlike Category I and II AIFs—which are strictly prohibited from borrowing except for temporary 30-day liquidity needs—Category III AIFs are permitted to employ leverage through cash borrowings and exchange-traded derivative positions, subject to rigorous statutory ceilings:
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| CATEGORY III AIF LEVERAGE FRAMEWORK |
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| |
| GROSS EXPOSURE = Gross Market Value of All Long & Short Securities Positions |
| + Notional Value of All Exchange-Traded Derivative Contracts |
| + Cash Borrowings & Liabilities |
| |
| LEVERAGE RATIO |
| |
| Gross Exposure |
| ----------------------------- <= 2.0x |
| Net Asset Value (NAV) |
| |
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- Statutory Cap: The total Gross Exposure of a Category III AIF shall not exceed two times (2x) the Net Asset Value (NAV) of the fund.
- Reporting to SEBI: Category III AIFs utilizing leverage must report their gross exposure, net derivative delta, value-at-risk (VaR), and stress-testing metrics to SEBI on a monthly and quarterly basis.
- Participation in Credit Default Swaps (CDS): Category III AIFs can participate in Credit Default Swaps as protection buyers (for hedging debt holdings) or protection sellers (provided unencumbered government securities or cash equivalents are maintained to cover the entire gross CDS obligation).
Category III AIFs operate under a robust supervisory and market integrity regime, integrating securities law compliance with cross-border capital rules.
1. Compliance Test Report (CTR)
The Investment Manager must prepare an annual Compliance Test Report (CTR) verifying compliance with:
- Portfolio concentration caps and leverage limits.
- Adherence to the stated investment strategy in the Private Placement Memorandum (PPM).
- Timely valuation and quarterly activity reports filed with SEBI.
- The CTR is reviewed and signed by the Trustee and submitted to SEBI annually.
2. Market Conduct Regulations: Insider Trading (PIT) and PFUTP
- SEBI (Prohibition of Insider Trading) Regulations, 2015: Because Category III AIFs trade listed equities and derivatives daily, managers and investment team members are classified as "Insiders" whenever they possess Unpublished Price Sensitive Information (UPSI). AIFs must maintain a Structured Digital Database (SDD) recording all shared UPSI, along with the names and PANs of recipients. Front-running, insider tipping, or trading ahead of client orders is strictly prohibited.
- SEBI (PFUTP) Regulations, 2003: Prohibits manipulative schemes, circular trading, wash trades, artificial volume creation, or spreading misleading market rumors.
3. Cross-Border Capital: FEMA and Downstream FOCC Rules
- Inflows of foreign capital into Category III AIFs must comply with the Foreign Exchange Management (Non-debt Instruments) Rules, 2019.
- Under the Foreign Owned or Controlled Company (FOCC) test, if the Sponsor and Manager are owned and controlled by resident Indian citizens, downstream investments into Indian portfolio companies are treated as domestic investments, even if foreign investors hold units in the AIF.