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Tata Capital > Blog > Wealth Services > All You Need to Know About Category II AIF

Wealth Services

All You Need to Know About Category II AIF

All You Need to Know About Category II AIF

If you’re looking to diversify your portfolio beyond traditional stocks and bonds, then Alternative Investment Funds (AIFs) are an excellent avenue. The Securities and Exchange Board of India (SEBI) has categorised these funds into three categories: Category I, Category II, and Category III.

Among these, Category II stands out as a popular choice among investors looking to leverage opportunities that are not typically accessible in the conventional market. Unlike Category I AIFs, which are incentivised for certain social or economic goals, and Category III AIFs, popular for their short-term and speculative investments, Category II AIFs offer a middle ground. They don’t benefit from specific incentives or concessions but are also not as aggressively speculative as Category III funds.

This article will delve into everything you need to know about Category II AIFs to make informed investment decisions.

What is category II AIF?

According to SEBI, AIFs that do not fall under Category I and Category III and do not undertake leverage or borrowing except for meeting everyday operational needs, fall under Category II.

Unlike Category I AIFs, these funds do not enjoy any specific government incentives or concessions. They operate under standard market conditions without any particular benefits. Category II AIFs have a moderate risk profile and come with a fixed term ranging from a few years to a decade.

Key Features Of Category II AIFs

Category II AIFs are designed for investors seeking diversified exposure with a moderate risk profile. Here are some features to expect: 

1. No leverage for investments: These funds do not use borrowing or leverage to enhance returns, except for short-term operational requirements as permitted by SEBI.

2. Moderate risk-return profile: Category II AIFs balance risk and return by investing in private equity, debt, and similar instruments. This makes them less speculative than Category III AIFs.

3. Fixed tenure structure: Most Category II AIFs have a defined tenure, typically ranging from 5 to 10 years, aligning with long-term investment strategies.

4. Focus on unlisted securities: Investments are primarily made in unlisted companies or instruments, offering access to opportunities not available in public markets.

5. Professionally managed: These funds are managed by experienced professionals who design strategies based on market conditions and fund objectives.

Types Of Funds In Category 2 AIF

Under Category II AIFs, you can invest in a variety of asset classes like:

1. Private equity funds

These funds typically invest in unlisted private companies to earn profit through eventual exits, such as IPOs, buybacks, or sales to other investors. Private equity funds have the potential for high returns but come with higher risk and longer investment horizons.

2. Debt funds

Debt funds in Category II AIF focus on investing in debt securities of unlisted companies. These can range from bonds and debentures to other fixed-income securities. These funds typically offer more stable returns compared to equity-oriented funds and are suitable for investors with a lower risk tolerance.

3. Fund of funds

Fund of funds (FoF) invest in various other AIFs, instead of directly investing in stocks, bonds, or other securities. It doesn’t have an investment portfolio but invests in a portfolio of other investment funds. But remember, unlike FOF under mutual funds, FOF of AIFs does not issue units of the fund publicly.

Who Can Invest in AIF Category 2?

Category II AIFs are not meant for all investor profiles and are best suited for those with higher risk appetite and longer investment horizons. You can invest in Category II AIFs if you fall under one of the following categories:

– High net-worth individuals (HNIs) who meet the minimum investment threshold

– Non-Resident Indians (NRIs) and foreign investors, subject to regulatory compliance

– Institutional investors such as banks, insurance companies, and pension funds

– Family offices and trusts seeking alternative investment exposure

These funds are generally suitable if you have surplus capital and do not require short-term liquidity.

Investment restrictions for Category II AIFs

While Category II AIFs offer a range of investment opportunities, they also come with certain restrictions laid out by SEBI. These restrictions help ensure investor protection. Here are some of the key investment restrictions for Category II AIFs:

1. Investments in this category must only be in unlisted securities. This aligns with the fund’s objective of seeking alternative investment avenues beyond the traditional stock market.

2. These funds can only borrow money to meet temporary requirements. The borrowing is further restricted to only 30 days and a maximum of 4 times a year. Additionally, the borrowed amount must not exceed 10% of its investible funds.

3. These funds are exempt from Insider Trading Regulations if they invest in SMEs listed on the SME Exchange and hold the securities for at least a year.

4. Category II AIFs can engage in hedging and can even invest in the unsubscribed portion of an IPO by making an agreement with the merchant banker.

Taxation of Category II AIFs

Category II AIF has a pass-through status. This means that the income earned by the fund is not taxed at the fund level but is passed on to the investor. The investor is then taxed per their tax bracket and the nature of the income. The Fund is liable for deduct tax (TDS) at 10% for residents and full tax for NRIs (except beneficial jurisdiction).

The Fund does not pay any tax at Fund level and the Investors are required to discharge the taxes (net of the taxes withheld by the Fund) on their respective share of income from the Fund at the applicable rates. 

The investor level taxation is as below:

-Long-term capital gains (LTCG): 10% on listed shares/ bonds/ debentures and 20% on unlisted shares / bonds / debentures.

-Short-term capital gains (STCG): Based on the investor’s tax slab; generally taxed at 15% for listed shares/bonds/debentures

-Dividend income: Taxed according to the investor’s tax slab.

-Interest income: Taxed according to the investor’s tax slab.

–Business Income: Taxed according to the investor’s tax slab

Final words

Category II AIFs offer a unique and diversified avenue for investors looking to venture beyond traditional investment options. The diverse range of funds under this category offers an excellent opportunity for effective portfolio diversification and tailored investment strategies.However, if you’re new to investments, it’s best to seek professional guidance. At Tata Capital Wealth, our experts can help you select the right investment avenue aligning with your financial goals and risk tolerance. Visit our website to start your investment journey today.

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FAQs

What is the minimum investment required for Category II AIF in India?

The minimum investment required for a Category II AIF in India is ₹1 crore per investor. For employees or directors of the fund, SEBI allows a lower minimum investment limit.

What types of funds are included under Category II AIFs?

Category II AIFs include private equity funds, debt funds, and fund of funds. These funds primarily invest in unlisted securities and alternative asset classes.

Are Category II AIFs suitable for retail investors?

Category II AIFs are generally not suitable for retail investors due to their high minimum investment requirement, longer lock-in periods, and higher risk compared to traditional products.

How is income from Category II AIFs taxed?

Income from Category II AIFs follows a pass-through taxation structure. You are taxed at your applicable rate based on the nature of income, such as capital gains, interest, or dividends.

What is the lock-in period or tenure for Category II AIFs?

Most Category II AIFs have a fixed tenure ranging from five to ten years. During this period, your investment remains largely illiquid, except under specific exit conditions.

How do Category II AIFs differ from Category I and III AIFs?

Category II AIFs neither receive government incentives like Category I nor use aggressive trading strategies like Category III. They offer a balanced approach with moderate risk and structured investment strategies.

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