Chapter 5: Alternative Investment Fund Ecosystem

Structural Participants in the AIF Operating Machine

An Alternative Investment Fund operates through an interconnected network of fiduciary, administrative, investment management, and custodial intermediaries governed by statutory contracts:

                            ┌────────────────────────────────────────┐
                            │               SETTLOR                  │
                            │  Establishes Trust with nominal corpus │
                            └───────────────────┬────────────────────┘
                                                │
                                                ▼
                            ┌────────────────────────────────────────┐
                            │               TRUSTEE                  │
                            │  Legal Owner of Assets; Fiduciary Duty │
                            └───────┬────────────────────────┬───────┘
            Appoints Manager        │                        │ Custody of Securities
                   ┌────────────────┘                        └────────────────┐
                   ▼                                                          ▼
┌──────────────────────────────────────┐                   ┌──────────────────────────────────────┐
│          INVESTMENT MANAGER          │                   │              CUSTODIAN               │
│ • Sourcing, Research & Execution     │                   │ • Safekeeping of Fund Securities     │
│ • Portfolio Risk & Leverage Mgmt     │                   │ • Demat / Physical Vaulting          │
│ • Mandatory CSCRF Compliance         │                   │ • Mandatory for all Cat III AIFs     │
└──────────────────┬───────────────────┘                   └──────────────────────────────────────┘
                   │
    ┌──────────────┴──────────────┐
    ▼                             ▼
┌───────────────────────┐   ┌───────────────────────┐
│      SPONSOR          │   │  CLEARING MEMBER      │
│ • Promotes the Fund   │   │ • Derivatives Margin  │
│ • 5% / ₹10 Cr Skin    │   │ • Trade Settlement    │
└───────────────────────┘   └───────────────────────┘

Roles and Fiduciary Responsibilities in Category III AIFs

1. The Settlor: Executes the Indenture of Trust and provides the initial nominal settlement amount (typically ₹10,000 to ₹1,00,000) to legally establish the trust vehicle.
2. The Trustee: Holds the legal title to all fund assets in trust for the collective economic benefit of the unit-holders. Under the Indian Trusts Act, the Trustee owes an absolute fiduciary duty to unit-holders and exercises continuous oversight over the Investment Manager.
3. The Investment Manager (AMC): The corporate entity contracted via the Investment Management Agreement (IMA) to manage the fund’s trading strategies, portfolio risk budgeting, execution algorithms, valuation coordination, and investor reporting.
4. The Sponsor: The promoter entity responsible for establishing the AIF, legally obligated to maintain a continuous, unencumbered skin-in-the-game commitment (for Cat III: 5% of the corpus or ₹10 Crores, whichever is lower).
5. The Custodian: An independent SEBI-registered entity mandated to maintain safe custody of the fund’s cash, securities, and collateral. Mandatory for all Category III AIFs regardless of corpus size.
6. Professional Clearing Member (PCM): In Category III AIFs that trade exchange-traded derivatives, the PCM manages margin collateral deposits, margin call settlements, and daily mark-to-market settlements with clearing corporations (NSCCL/ICCL).
7. Registrar and Transfer Agent (RTA): Maintains the unit-holder register, processes subscriptions and redemptions, executes unit allotments, conducts KYC/AML checks, and issues capital statements.

Capital Calling Mechanics in Close-Ended vs Open-Ended Category III Funds

Category III AIFs can be structured as either Close-Ended or Open-Ended funds, resulting in distinct capital collection mechanics:

Capital Commitment Architectures:
1. Close-Ended Funds (Staged Drawdown Model):
[Commitment Signed] ──> [Drawdown Notice Issued] ──> [T+10 to T+15 Days] ──> [Units Allotted]

2. Open-Ended Funds (Periodic Subscription Model):
[Application Submitted] ──> [Capital Injected Upfront] ──> [Allotted at Periodic NAV]

Defaulting Investor Mechanics in Close-Ended Schemes

When an investor in a close-ended Category III AIF fails to honor a capital call within the specified notice window and subsequent cure period (usually 15 to 30 days), the LP is declared a Defaulting Investor:

Standardized Private Placement Memorandum (PPM) Framework

To protect investors and ensure transparency, SEBI mandates a Standardized PPM Template across all Category III AIFs, divided into:

• Part A: Standardized core disclosures (investment philosophy, team background, fee structures, operating expense caps, leverage policies, conflict management, and risk factors).
• Part B: Fund-specific supplementary information (proprietary quantitative models, historical backtests, execution infrastructure).

PPM Compliance Governance Loop:
┌─────────────────────────┐      Annual Audit      ┌─────────────────────────┐
│ Standardized PPM Part A ├───────────────────────>│ Independent Audit Firm  │
│ (Core Statutory Terms)  │                        │ (CA or Company Sec.)    │
└─────────────────────────┘                        └───────────┬─────────────┘
             ▲                                                 │
             │              Annual Findings Filed              ▼
             └─────────────────────────────────────── [SEBI & Trustee Board]

Annual PPM Compliance Audit

SEBI mandates that every Category III AIF conduct an Annual Compliance Audit of its PPM terms by an independent chartered accountant or company secretary:

• Verifying whether actual leverage remained strictly within the 2x NAV limit.
• Verifying that single-investee exposures did not breach the 10% statutory cap.
• Ensuring that all fees, expenses, and transaction costs charged to the scheme remained within the exact caps disclosed in Part A of the PPM.
• The audit report must be placed before the Trustee and the Board of the Manager, and filed with SEBI within 6 months from the end of the financial year.

Cyber Security and Cyber Resilience Framework (CSCRF 2024)

In August 2024, SEBI notified the unified Cyber Security and Cyber Resilience Framework (CSCRF):

• Mandatory appointment of a designated Chief Information Security Officer (CISO).
• Establishing air-gapped data retention, immutable trading audit trails, and multi-factor authentication (MFA) across all algorithmic execution gateways and investor portals.
• Mandatory bi-annual cyber audits and periodic vulnerability assessments and penetration testing (VAPT).
• Incident reporting obligation requiring cyber breaches to be formally reported to SEBI and CERT-In within 6 hours of detection.