Category I, II and III AIFs Compared: What Each Is For

There are three categories of Alternative Investment Fund and every registered vehicle sits in exactly one of them. The three differ in purpose and in structure rather than in performance. The Securities and Exchange Board of India fixes the conditions attaching to each, its current text at sebi.gov.in is the only reliable source, and those conditions change, so five invented vehicles are worked through instead.

Most people come to this subject wanting one specific thing: a number. The minimum somebody has to put in, the smallest size a fund can be, the share the manager has to contribute, the years it has to run, how much it can borrow, how many investors it can take. Not one of those quantities can be learned reliably from a general account, and grasping that is the single most useful thing anybody takes away from this subject. Every one of those quantities is set by a regulator, is true on a date, and is amended from time to time. A source that supplies one is supplying a figure a reader will carry in the head, use with confidence, and never go back and check.

Three things about the categories can be relied on where a table of conditions cannot. Why a categorisation exists at all is a structural question with a real answer. A category determines something real, statable in plain words even when its contents cannot be stated. And the procedure for finding the answer for one fund on one day is the skill that keeps working after every figure in every explainer has gone out of date.

Why does one registered form need three categories at all?

Start somewhere ordinary. A housing society keeps one parking register for the whole building. The register is one form with one set of columns, and every vehicle in the compound is written into it. A scooter, a hatchback and a delivery van are not the same problem, so the register has three sections. The three need different amounts of space, come and go at different hours, and the van blocks a gate that a scooter never gets near. The society did not create three registers. The alternative was either three separate systems or one set of columns that fits nothing properly, so the society created one register with three sections.

A registered pooled private vehicle in India has the same problem at a much larger scale. An Alternative Investment FundA pooled private vehicle registered in India in one of three categories. is one legal form under which a great many structurally different things get done. One vehicle raises promises from a small number of investors, calls that money in instalments over several years, buys controlling stakes in unlisted companies and sells them again. Another lends money and collects interest. Another buys buildings and infrastructure. Another takes money in continuously, trades listed instruments, and lets people leave on a contracted calendar. Buying control, lending, holding buildings and trading are not variations of one activity but four different businesses that happen to share a wrapper.

The things that could go wrong in a fund that lends, a fund that buys control and a fund that trades are not the same things, so a single set of terms cannot govern all three. A lending vehicle's central question is whether it gets repaid. A control vehicle's central question is what happens to a business it is running. A trading vehicle's central question is what happens when many people want their money back on the same day. One rulebook that covers all three properly is three rulebooks bound together. One that covers all three loosely covers none of them. A categoryA registration class, which fixes what a vehicle may do rather than how it performs. system is how one registered form carries several structures without pretending they are the same structure.

Nilgiri Alternatives Advisors Private Limited, invented, is the manager worked through here. The manager runs six vehicles. One of them, Nilgiri Growth Partners Fund I, is wound up, and its category is unstated because the record it is drawn from carries none. The other five are live and spread across all three categories. Here they are.

Category I vs Category II vs Category III AIF: what does that split actually decide?

Here is where most explanations of this subject go wrong, and it is worth being precise about the wrongness. Most explanations present the three categories as three descriptions of investment style, as though naming one identified what the fund buys. It does not. The category is a registrationThe act of being entered on a regulator's list, which carries conditions set by that regulator. class. The class records where a vehicle sits on a regulator's list. Two vehicles in the same category can look nothing like each other, as the picture above shows on this record alone, and two vehicles that look almost identical from the outside can sit in different ones.

The category decides something real, though, and it can be named exactly even where its contents cannot. Which category a fund falls into changes three kinds of thing. The category changes what the vehicle may do. The category changes how the vehicle may be structured. And the category changes how the vehicle is treated. Conduct, structure and treatment are the whole of what a category governs. The fact that they are governed can be stated plainly. The content of each is set by the Securities and Exchange Board of India at sebi.gov.in, and it changes.

Leaving those conditions blank is a promise rather than a dodge. A fund described as a Category II Alternative Investment Fund is a fund for which exactly three questions have been answered somewhere, by a body that can be named. Knowing that much is more than most readers of this subject walk away with, and unlike a remembered figure it does not decay. The comparison below is built on that split: everything above the dark strip is a fact about an invented vehicle and can be stated; everything below it is a condition and cannot.

What is a category, and what is the one thing it is not?

A category is a registration class. A registration class is a line in a list held by a regulator, recording that a particular vehicle has been entered under a particular heading. The line in the list is a small, dry, administrative fact that also determines a great deal about the vehicle, and the mismatch between those two is exactly why the category gets misread.

The one thing it is not is a description of investment style. Look again at what this record shows. Nilgiri Growth Partners Fund II, invented, buys large stakes in unlisted companies and sits on their boards. Nilgiri Direct Lending Fund I, invented, writes loans and collects interest. Nilgiri Real Assets Fund I, invented, buys buildings and infrastructure. The three vehicles do not resemble each other in what they buy, in what can go wrong, in how a return arrives or in what a reader would have to check about them. All three are registered in the same category, and that fact says nothing whatever about which of the three is in front of a reader.

Go back to the parking register for a second. The analogy holds all the way down. A vehicle written in the cars section is a vehicle in that section of the register, and roughly a certain shape of thing. The section does not give the colour, who drives it, whether it is insured, or whether it has moved in a year. Colour, driver, insurance and use come from looking at the vehicle. And crucially, the rules attaching to each section are on a notice board that the secretary updates, so the board is what gets read rather than somebody's memory of the board. Every part of that maps onto this subject exactly.

What is Category I for, and which invented vehicle sits there?

The purpose of Category I shows up by way of the vehicle registered there in this record. Not because the wider purpose is a secret, but because any general statement of it that carried real content would be a statement of what the category permits, and that is the regulator's to set.

So: Nilgiri Venture Fund I, invented, is registered as a Category I Alternative Investment Fund. The fund has Rs 1,50,00,00,000 committed to it and holds eighteen investments. The fund puts money into unlisted companies at funding rounds, at a stage where those companies are young and have no established price for their shares, and then holds those positions while the companies either grow into something or do not. Nilgiri Venture Fund I is a closed-end vehicleOne with a fixed life, commitments called in instalments, and no redemption right.: investors promise a sum, the manager calls it in instalments as investments are made, and nobody has a right to ask for their money back on a Tuesday.

One more thing belongs here. Category I is itself divided further, into a set of named kinds of vehicle of which the venture capital fund is one. The named kinds are compared against each other separately, and only the venture capital fund is needed here. Everything about what distinguishes them, and everything attaching to any of them, sits with the Securities and Exchange Board of India at sebi.gov.in.

What is Category II for, and why do three unlike vehicles share it?

Category II is where the misreading breaks in the most visible way. Three of this manager's five live vehicles are registered as Category II Alternative Investment Funds. The three have Rs 5,00,00,00,000, Rs 3,00,00,00,000 and Rs 4,00,00,00,000 committed to them respectively, or Rs 12,00,00,00,000 between them, and they buy three completely different things.

Nilgiri Growth Partners Fund II, invented, buys large stakes in nine unlisted companies, sits on their boards, and makes money if a later buyer pays more than it did. Nilgiri Direct Lending Fund I, invented, does not buy companies at all: it lends to them, takes security, and makes money if the borrower pays the interest and returns the principal. Nilgiri Real Assets Fund I, invented, buys buildings and infrastructure, and makes money from what the asset earns while it is held and from what somebody pays for it at the end. A reader told only that all three are Category II vehicles has been told the one thing about them that is identical and nothing about the three things that are not.

The spread across those three does something to a reader's instincts. A reader who learns that a fund is a Category II Alternative Investment Fund and concludes that its business is now roughly known has just been falsified three times over by three vehicles run by the same manager. The category is upstream of the strategy, not a summary of it.

What is Category III for, and what does that vehicle do differently?

Nilgiri Absolute Return Fund, invented, is registered as a Category III Alternative Investment Fund. The fund had Rs 5,00,00,00,000 of net assets at the record date, and that date falls at the end of Nilgiri Growth Partners Fund II's Year 9 Q2. The fund is also an open-ended vehicleOne that takes subscriptions and pays redemptions on a continuing basis.. An open-ended structure is genuinely different from the other four in this record, and not a matter of degree.

Take the difference slowly. The structural difference is the one thing here that can be seen from the outside without reading any rule. In the four closed-end vehicles, an investor makes a promise. The money stays in the investor's bank account until the manager asks for a piece of it, and the asking is called a capital call. In the open-ended vehicle nothing is promised. The money arrives at the front: an investor subscribes, and the cash is in the fund from that moment. There is therefore no capital call in Nilgiri Absolute Return Fund, invented, not as a matter of choice or of policy, but because there is nothing outstanding for a call to reach.

The same fact runs out the other end. A closed-end vehicle has a term and pays out as things are sold. The open-ended one has a dealing calendarThe contracted dates on which an open-ended vehicle accepts subscriptions and redemptions. instead, and this fund deals quarterly under its own contracted terms. An investor who wants out asks on the calendar rather than waiting for a sale. The terms governing that calendar are this invented fund's own contracted terms and are covered separately, for exactly the same reason the regulator's conditions are: a half remembered term is worse than no term.

What is visible from the outside without reading any rule?

Quite a lot, as it turns out. The structural difference between the four closed-end vehicles and the open-ended one shows up in what actually happens to money, so not a single condition is needed to see it.

Nilgiri Growth Partners Fund II, invented, is the clearest instance in this record. Rs 5,00,00,00,000 was promised to it. By the end of its Year 9 Q2, Rs 4,80,00,00,000 had actually been called, in seventeen separate drawdowns, or 96.0 per cent of what was promised. The remaining Rs 20,00,00,000 is still a promise: it has been committed to the fund and has not been asked for. Nilgiri Absolute Return Fund has no unfunded balance at all, so there is no equivalent sentence to write about it. Its Rs 5,00,00,00,000 is money, not a promise about money.

One warning about arithmetic, and it is a trap that catches careful people. Adding the five figures up is tempting and wrong. Rs 1,50,00,00,000 plus Rs 5,00,00,00,000 plus Rs 3,00,00,00,000 plus Rs 4,00,00,00,000 is Rs 13,50,00,00,000 of commitments, and that total is real. The fifth figure, Rs 5,00,00,00,000 of net assets, is not a commitment at all: it is a measured value on a date. Adding a promise to a measured value produces a number that answers no question, and the fact that the two arrive in the same units is exactly what makes the mistake easy. Keep the two totals apart and say which is which.

Where does every condition actually live, and how is it reached?

The practical payload is a procedure rather than a fact, and that is precisely why it keeps working. There are four places to go, in order, and the fourth one is the step almost everybody skips.

First, the fund's own documents. A specific fund states its own category in its own constitutional and offering papers. The category a particular fund is registered in is recorded there, and no general account can supply it. No general account knows which fund a reader is holding. Second, the fact of registration itself. A registered vehicle appears on the regulator's list, and that entry is a public record of where it sits rather than a matter of the manager's description. Third, and this is where the conditions themselves live, the current text published by the Securities and Exchange Board of India at sebi.gov.in. Everything left blank here is set there.

Fourth, and this is the one that separates somebody who can actually use this from somebody who has merely read about it: the date of reading. Conditions are amended. A condition without the day it was read attached is not yet a usable answer. There is no way to tell whether it is the current one. A figure quoted from memory is a figure that cannot be checked, and a figure that cannot be checked is worth less than an honest blank. The blank at least points somewhere.

Why would taking a condition off a teaching note be the mistake?

Because of what happens to a number after it has been learned. The point is worth being blunt about. A reader who does not accept the argument will reasonably think the blanks are unhelpful.

Every quantity on this subject that could sensibly sit under a control is a condition set by a regulator, and putting one under a slider would state a value, imply a range around it, and invite a reader to reason about where inside that range a particular vehicle sits. A blank that names its source teaches. A blank left without a reason is only a gap.

How should a category label be used when one turns up?

Labels turn up constantly: in a fund's first paragraph, in a news item, in a company's shareholder list, in an interview question. Handling one comes down to three questions that take about ten seconds to ask.

Worked through in order, the three save a great deal. Does the label show what the fund holds? No, and this record has demonstrated that three times over inside one category. The holdings come from the fund's own documents, and so do the charges and the terms on which an investor is able to leave. Does the label show the conditions attaching to it? No, and nobody writing a general account can honestly supply them either. The conditions come from the Securities and Exchange Board of India at sebi.gov.in, read on a day that gets noted.

So the label gives two things: where the fund sits, and the fact that three kinds of question have been settled somewhere. The label is an address rather than a description. An address sounds like less than a reader wanted until it is set against the alternative. A reader who thinks the label is a description will stop reading at the label. A reader who knows it is an address will open the documents, where the answers about that particular fund were always going to be.

What does somebody who does this for a living actually do with a category?

Three different people, three different uses, and none of them involves remembering a condition.

Start with an analyst handed a fund's papers for the first time. The category tells them which regulator to check the vehicle against and which set of questions has been answered elsewhere, so they do not waste an afternoon looking for those answers in the documents. Then they read the documents for the things only the documents hold: what the fund buys, what it charges, how long it runs, what happens if a key person leaves. The category has saved them time by telling them where not to look. The category has told them nothing about the fund.

Next, a credit team at a lender looking at a company that has a private fund among its shareholders. The credit team wants to know whether that shareholder is likely to put more money in if the company gets into difficulty, and whether it has the standing to be asked. The category tells them which list the shareholder sits on and therefore that a real registration exists behind the name. The category does not tell them the shareholder's appetite, its remaining uncalled capital, or its investment period, all of which sit in that fund's own papers or nowhere at all. Treating the registration as evidence about behaviour is the same error as treating it as evidence about strategy, one step further along.

Third, and this is the one that will reach most readers: somebody in an interview or an examination who is asked what the three categories are. The strongest possible answer is not a recited condition. The answer is this: they are three registration classes under one form, the category fixes what a vehicle may do, how it may be structured and how it is treated, the conditions themselves are set by the Securities and Exchange Board of India at sebi.gov.in and change over time, and here is a case where three vehicles doing three unrelated things share one of them. The answer is correct today, correct in two years, and shows an understanding of what kind of thing the question is about.