AIF Structuring, Compliance, and Distribution Waterfalls

Alternative Investment Funds (AIFs) play an increasingly strategic role in India’s investment ecosystem. For fund managers, legal advisors, and institutional investors, aligning with SEBI’s regulatory framework is essential to preserve fund integrity, attract capital, and operate without disruption. This article outlines key aspects of AIF structuring, regulatory compliance, and distribution waterfalls under SEBI’s evolving rules.

Understanding SEBI’s AIF Regulatory Framework

The Securities and Exchange Board of India (SEBI) regulates AIFs under the SEBI (Alternative Investment Funds) Regulations, 2012. These regulations classify AIFs into three categories based on their investment strategies and risk profiles:

• Category I AIFs invest in early-stage ventures, infrastructure, small and medium enterprises (SMEs), and social impact sectors.

• Category II AIFs include private equity, private credit, and real estate funds. These funds operate without leverage, apart from temporary borrowings.

• Category III AIFs pursue complex strategies including public market trades, long-short positions, and arbitrage. These funds may employ leverage subject to risk and exposure controls.

Each category has specific norms related to permissible investments, exposure limits, and fund governance.

Structuring an AIF: Legal and Strategic Considerations

Setting up an AIF involves a series of decisions that determine regulatory classification, investor suitability, and operational viability.

• Choice of Legal Vehicle: AIFs may be established as a trust, LLP, or company. Trust structures remain the most commonly used due to tax efficiency and streamlined governance.

• SEBI Registration: Applicants must submit a Private Placement Memorandum (PPM) detailing investment objectives, fund structure, risk factors, valuation methodology, and governance model. SEBI reviews all disclosures for regulatory clarity and investor protection.

• Investment Strategy Definition: The PPM must provide a clear description of target asset classes, expected risk-return profile, sectoral focus, and capital deployment methodology.

• Governance and Compliance Setup: Larger funds (AUM above ₹500 crore) must appoint independent custodians. Managers must also establish internal controls for monitoring capital calls, investment limits, investor rights, and reporting cycles.

Errors in structuring or documentation may lead to registration delays or future enforcement risks.

SEBI Compliance Obligations for AIFs

Maintaining regulatory alignment involves continuous compliance with SEBI requirements throughout the fund lifecycle:

• Minimum Capital Requirements: AIFs must raise at least ₹20 crore, with a minimum commitment of ₹1 crore per investor. For fund employees or managers, the threshold stands at ₹25 lakh.

• Exposure Norms: Category I and II AIFs cannot invest more than 25% of their investible corpus in a single investee company. Category III funds operate under leverage and exposure limits tied to NAV-based calculations.

• Leverage Restrictions: Only Category III AIFs are permitted to use leverage, and only within approved risk management frameworks.

• Reporting Obligations: Quarterly reports must be submitted to SEBI. Annual audits and investor updates covering portfolio holdings, risks, and material changes are also required.

• Custodian Appointment: Mandatory for all Category III AIFs and for Category I/II funds with assets exceeding ₹500 crore.

Distribution Waterfalls: Structuring Profit Allocation

SEBI mandates transparency in the manner in which AIFs allocate profits to investors and fund managers. The distribution waterfall outlines the order in which proceeds are shared. A typical structure includes:

1. Return of Capital: All capital contributed by investors is returned in full before any profit-sharing begins.

2. Preferred Return: Investors receive a fixed hurdle rate (commonly 8%) as the first tranche of profits.

3. Catch-Up (if applicable): The manager may receive a higher share until carry aligns with the agreed percentage.

4. Carried Interest: A defined share of excess profits (usually 15–20%) is allocated to the fund manager.

5. Residual Proceeds: Any remaining profits are distributed in accordance with the fund agreement.

The PPM must describe this sequence in detail, including provisions for clawback, audit, and investor review.

Key SEBI Guidelines on Fund Governance

SEBI continues to strengthen the compliance landscape for AIFs through directives and circulars that emphasize risk management and investor protection:

• Valuation Methodologies: SEBI expects fair, consistent, and independently verified valuation practices across asset classes.

• Redemption and Lock-In Policies: The redemption structure must match the fund’s asset liquidity profile. Premature exits must be restricted to avoid cash flow imbalances.

• No Cross-Scheme Subsidisation: Funds must not pool risks, expenses, or returns across separate AIF schemes. Each scheme must be independently managed and accounted for.

• Tax Clarity: Category I and II funds often enjoy pass-through status under Indian tax laws, while Category III funds are taxed at the fund level. Fund structuring must account for this distinction.

Case Study: SEBI Enforcement on Exposure Violation

A Category II AIF was recently penalized for allocating over 40% of its corpus to a single investee company—exceeding the prescribed 25% cap. SEBI required the fund to restructure its holdings, file revised disclosures, and pay regulatory penalties. This case highlights the importance of real-time monitoring of investment concentration and strong internal compliance systems.

Best Practices for AIF Managers

To ensure long-term regulatory and operational stability, fund managers should:

• Maintain an updated compliance calendar with reporting deadlines and audit timelines.

• Standardize investor communications across NAV updates, capital calls, and distribution notices.

• Document investment committee decisions and risk assessments for SEBI and investor audit readiness.

• Align fund liquidity, asset class duration, and distribution models to avoid cash flow or redemption mismatches.

Concluding thoughts

The AIF industry continues to grow in scale and complexity. SEBI’s regulatory framework provides sufficient flexibility to support innovation, while enforcing standards that build investor confidence. For fund managers, regulatory alignment must go beyond documentation—it should reflect in fund design, governance, and day-to-day decision-making.

Adopting a proactive compliance approach enables managers to focus on performance while maintaining investor trust and regulatory continuity.