Chapter 5: Regulatory Framework (Part 5 of 6)
5.16 General Obligations and Responsibilities of a Category III AIF
Registered Category III Alternative Investment Funds (AIFs) must comply with a robust set of general obligations and operational responsibilities mandated under the SEBI (Alternative Investment Funds) Regulations, 2012. These standards ensure fiduciary accountability, strict internal controls, and investor protection across the fund's lifecycle.
5.16.1 Fiduciary and Operational Mandates
| No. | Duty / Requirement | Key Action |
|---|---|---|
| 1 | Appoint SEBI-Registered Custodian | Appoint a SEBI-registered custodian where mandatory under applicable regulations |
| 2 | Joint Manager–Trustee Policies & Procedures | Establish coordinated policies and procedures between the Investment Manager and Trustee |
| 3 | Dual-Compliance Investment Committee Rules | Implement Investment Committee processes that comply with applicable regulatory and governance requirements |
| 4 | Ring-Fence Assets & Liabilities | Maintain scheme-wise segregation of assets and liabilities |
| 5 | Annual Audit & Record Retention | Maintain audited annual financial statements and retain required records for 5 years |
1. Appointment of Custodian
The Sponsor or Manager of a Category III AIF must compulsorily appoint a SEBI-registered Custodian for the safekeeping of the fund’s securities and assets.
- Physical Goods Custody: The custodian is also responsible for keeping custody of securities and tangible goods received in delivery against the physical settlement of commodity derivatives.
- Independence: The custodian must not be a related party to the sponsors, managers, or designated partners unless specific regulatory exemption conditions are fulfilled.
- Timing of Appointment: The custodian for a scheme of an AIF must be appointed prior to the date of the first investment of the scheme.
2. Policies and Procedures
All Category III AIFs must put in place detailed policies and procedures to ensure that all decisions of the fund comply with SEBI regulations, the terms of the Private Placement Memorandum (PPM), agreements entered into with investors, and all other applicable laws.
- Joint Approval: These policies must be jointly approved by the Investment Manager and the Trustee (or Trustee Company/Directors of the Trustee).
- Review and Compliance: The Investment Manager is responsible for reviewing these policies and their execution on a regular basis. The Manager holds ultimate responsibility for every decision made by the AIF.
3. Investment Committee Framework
An Investment Manager can constitute an Investment Committee (by whatever name called) to review and approve the investment decisions of the scheme. However, the operation of this committee is subject to strict guidelines:
- Joint Compliance Responsibility: The Investment Manager and the members of the Investment Committee are held jointly and severally liable to ensure that all investments of the fund adhere to SEBI Regulations, fund documents, and the PPM.
- The Large Value Fund (LVF) Exemption: The joint liability of Investment Committee members does not apply to Large Value Funds (LVFs) for Accredited Investors, provided that:
- Each investor in the LVF (other than the Sponsor, Manager, or their employees/directors) has committed to invest a minimum of Rs. 70 crore (or its equivalent in foreign currency).
- Each investor has furnished a formal waiver in the SEBI-prescribed format releasing the committee members from joint liability.
- Appointment of External Members: Any external member appointed to the Investment Committee whose name was not originally disclosed in the PPM at the time of onboarding investors can only be appointed with the consent of at least 75% of the investors by value of their investment in the fund.
- Ex-officio Exception: Consent is not required for changes in ex-officio external members who represent the Sponsor, Sponsor Group, Investment Manager Group, or institutional investors acting in their official capacity.
4. Change in Control of Sponsor or Manager
Any proposed change in the control of the Sponsor and/or the Investment Manager of a Category III AIF requires prior approval from SEBI.
- NCLT Schemes of Arrangement: If the change in control is part of a corporate scheme of arrangement awaiting sanction from the National Company Law Tribunal (NCLT) under the Companies Act, the Category III AIF must proactively file an application seeking SEBI’s approval before the final NCLT order is passed.
5. Scheme Segregation and Ring-Fencing
The Investment Manager and the Sponsor must ensure that the assets and liabilities of each scheme of an Alternative Investment Fund are strictly segregated and ring-fenced from other schemes of the same fund. Additionally, the bank accounts and securities accounts of each individual scheme must be kept completely separate and ring-fenced.
6. Maintenance of Records and Audits
- Audit Requirement: The books of accounts of a Category III AIF must be audited annually by a qualified independent auditor.
- 5-Year Retention Policy: The Sponsor and/or Investment Manager are legally obligated to maintain all critical records for at least 5 years after the winding up of the fund. These records include:
- Assets held under each scheme.
- Valuation policies, models, and practices.
- Investment strategies and detailed investment decision-making processes.
- Detailed registers of investors, their KYC, and their exact capital contributions.
7. SEBI Inspections
SEBI retains the right to appoint one or more persons as an Inspecting Authority to inspect the books of account, records, and files of an AIF. The Sponsor, Manager, and all officers of the AIF are legally required to cooperate fully, provide all requested information, and produce any books or documents required by the Inspecting Authority.
5.16.2 Pro-Rata Rights and the Pari-Passu Principle
A foundational pillar of AIF regulation is that all investors in a scheme must be treated equitably, with their rights and distributions structured on a pro-rata and pari-passu basis.
| Feature | Standard Category III AIF | Large Value Fund (LVF) |
|---|---|---|
| Basic Rule | Investors generally have pro-rata rights according to their commitments | Exempt from pari-passu requirements post-13 December 2024, subject to applicable conditions |
| Differential Rights | Permitted only when they do not prejudice the interests of other unitholders | Greater flexibility to provide differential rights |
| Loss Sharing | Priority distribution of losses is not permitted | Differential arrangements may be permitted subject to applicable disclosure and waiver requirements |
| PPM Disclosure | Differential rights should be appropriately disclosed | Explicit disclosure in the PPM required |
| Investor Consent | — | Signed investor waiver / undertaking required |
1. Pro-Rata and Pari-Passu Rights
Investors in an AIF scheme must have rights that are pro-rata to their capital commitments in the scheme. This applies to every investment made by the scheme and to the distribution of proceeds from those investments.
- Grandfathering Clause: The rights of investors in schemes launched prior to November 18, 2024, which are not pro-rata to their commitments and not specifically exempted by SEBI, must be resolved in a manner specified by SEBI.
2. Permissible Differential Rights
An Investment Manager may offer differential rights to select investors (such as lower management fees or side letter terms) without affecting the interests of other investors in the scheme, subject to the following strict guiding principles:
- No Accrual of Liability: The differential rights must not result in any investor accruing a liability toward other investors within the AIF scheme.
- No Decision-Making Control: Non-monetary or non-commercial differential rights must not provide the selected investor with control over the decision-making process of the AIF scheme, unless that investor is a formal member of the Investment Committee.
- No Alteration of Existing Rights: The differential terms must not alter, dilute, or degrade the existing rights available to other unitholders.
- SFA Standard Compliance: Differential rights can only be provided in accordance with the implementation standards formulated by the Standard Setting Forum for AIFs (SFA).
- Transparency and Disclosure: All differential rights, the eligibility criteria to receive them, and the process for an eligible investor to opt for them must be transparently disclosed in the scheme's PPM.
3. Large Value Fund (LVF) Exemption
The requirement to maintain strict pari-passu rights among investors does not apply to Large Value Funds (LVFs). For new LVFs whose PPMs are filed with SEBI after December 13, 2024, the fund may offer differential rights that affect the interests of other investors, subject to:
- Making a prominent, explicit disclosure of this exemption in the PPM.
- Obtaining a signed undertaking from each Accredited Investor at the time of onboarding containing this exact clause:
"The prospective investor is aware that LVFs may avail exemption from the requirement of maintaining pari-passu rights among investors and therefore, may offer differential rights to select investors which might affect interest of other investors of the LVF."
- Existing LVFs can also avail of this exemption, provided that every single investor in the scheme signs and provides the waiver clause.
- The Trustee or Sponsor must record compliance with this requirement in the annual Compliance Test Report (CTR) submitted to SEBI.
5.16.3 The SEBI Code of Conduct
The SEBI (AIF) Regulations mandate a comprehensive Code of Conduct under the Fourth Schedule. This code applies to the AIF, its Trustees, Directors, Sponsors, Investment Managers, and Key Management Personnel (KMP).
I. Code of Conduct for Alternative Investment Funds (AIFs)
The fund itself must adhere to the following operational principles:
- Objective Alignment: Carry out business activities and invest strictly in accordance with the investment objectives stated in the PPM and fund documents.
- Investor Interest Priority: Operate and manage the fund solely in the interest of all investors and not favor any select class of investors to the detriment of others.
- Dissemination of Information: Disseminate adequate, accurate, explicit, and timely information to all unitholders.
- Written Record of Decisions: Maintain a written record of every investment, divestment, and key business decision, along with the appropriate underlying justifications.
- Bona Fide Transactions Only: Do not enter into collusive or artificial arrangements for the sale or purchase of securities where there is no effective change in beneficial interest, or where the transfer is merely between parties acting in concert, unless there are valid and documented legal reasons.
- Strict Confidentiality: Maintain complete confidentiality of investors' personal investments and information, and never make improper use of such data.
II. Code of Conduct for Investment Managers and KMPs
The Investment Manager and its key personnel must uphold these professional standards:
- Fiduciary Duty: Act in a strict fiduciary capacity toward all investors and ensure that all investment decisions are made solely in their best interest.
- Highest Ethical Standards: Maintain integrity, professional competence, and independent professional judgment in all dealings.
- No Misleading Claims: Refrain from making any misleading or inaccurate statements, whether oral or written, regarding their qualifications, historical achievements, or investment management capabilities.
- Conflict Mitigation: Disclose details of any potential or actual conflicts of interest in a timely manner and implement approved mitigation policies.
- No Unethical Conduct: Abstain from any unethical market practices, professional misconduct, or acts of omission/commission that could lead to fraud or gross negligence.
5.16.4 Exemption Sandbox and Transparency Standards
1. Regulatory Sandbox Exemptions
To foster innovation and allow the testing of new financial products, processes, or technologies in a live market environment, SEBI may grant a Category III AIF a temporary exemption from certain regulations.
- Time Limit: The regulatory sandbox exemption cannot exceed a period of 12 months.
- Sandbox Conditions: The applicant must satisfy all specified conditions, and comply with operational guidelines on a continuous basis.
2. Transparency and Periodic Disclosures
Category III AIFs must maintain absolute transparency by disclosing the following details to investors:
- Complete financial performance, portfolio asset allocations, and risk management activities.
- The exact fee structures charged by the Investment Manager, Sponsor, and any of their "associate" entities.
- Any material liabilities arising during the tenure of the fund.
- Any regulatory inquiries, legal actions, or disciplinary proceedings initiated by SEBI or other financial authorities.
- Details of any change in control of the Sponsor, Manager, or key investee companies.
- Systemic Risk Reporting: The AIF must provide all required information to SEBI for systemic risk identification, analysis, and market mitigation.
3. Valuation Independence
To ensure unbiased reporting, the calculation of the Net Asset Value (NAV) of the Category III AIF must be kept completely independent from the fund management function of the Investment Manager.
- Disclosure Frequency: The calculated NAV per unit must be formally disclosed to investors at:
- Quarterly intervals for close-ended schemes.
- Monthly intervals for open-ended schemes.
- Independent Valuer: The valuation of unlisted securities and listed debt securities held in the portfolio must be conducted by an independent registered valuer.
5.17 Winding-Up and Winding-Up Scenarios
Close-ended Category III AIF schemes must be formally dissolved and wound up at the end of their fund cycle or upon the completion of their tenure as specified in the PPM.
5.17.1 Winding-Up Scenarios
An AIF scheme can enter winding-up proceedings under any of the following four scenarios:
- Tenure Expiry: The pre-defined tenure of the fund or scheme, as specified in the PPM, has concluded.
- Trustee Opinion: The Trustee (or Trustee Company) opinion concludes that the scheme should be wound up in the best interest of the unitholders.
- Unitholder Resolution: At least 75% of the investors by value of their investment in the scheme pass a formal resolution at a meeting of unitholders to wind up the scheme.
- SEBI Directive: SEBI directly orders the fund to wind up in the interest of the capital markets or to protect investors.
Note: If the AIF is set up as a company, an LLP, or a Body Corporate, its winding-up is governed by the respective provisions of the Companies Act, 2013, the Limited Liability Partnership Act, 2008, or the state/central statute under which it was established.
5.17.2 The Liquidation Period and In-Specie Distribution
Upon the initiation of winding-up proceedings, the fund enters a mandatory timeline to liquidate assets and make terminal distributions.
| Option | Key Requirement / Process | Investor Consent / Limit |
|---|---|---|
| Standard 1-Year Liquidation | Sell portfolio assets and distribute cash to investors | Unsold assets may be distributed in-specie with 75% investor consent by value |
| Dissolution Period | Continue specifically for liquidation of unliquidated investments | Requires 75% investor consent by value |
| Dissolution Period | No new capital commitments during the period | Maximum tenure = original fund tenure |
1. The Standard Liquidation Period
- 1-Year Timeline: The assets of the Category III AIF scheme must be liquidated within a Liquidation Period of 1 year following the expiry of its tenure or extended tenure.
- In-Specie Distribution Option: If certain portfolio assets cannot be sold due to an absolute lack of market liquidity during the winding-up process, the AIF can distribute these assets in-specie (in their physical, unliquidated form) to the investors. This requires the prior written approval of at least 75% of the investors by value of their investment in the scheme.
2. The Dissolution Period
As an alternative to in-specie distribution at the end of the 1-year liquidation period, the fund can enter a dedicated Dissolution Period to liquidate its remaining unliquidated assets.
- Investor Consent: Entering a Dissolution Period requires the approval of at least 75% of the investors by value.
- Filing Requirements: The AIF must file an information memorandum with SEBI through a registered Merchant Banker, accompanied by a due diligence certificate.
- Strict Time Limit: The tenure of the Dissolution Period must not exceed the original tenure of the AIF scheme and cannot be extended under any circumstances.
- No Operational Activity: The scheme is strictly prohibited from accepting any fresh capital commitments or making any new investments during the Dissolution Period.
- Mandatory Valuation: Before seeking investor consent, the AIF must disclose the proposed tenure, the specific assets to be liquidated, and a fresh valuation of these unliquidated assets carried out by two independent valuers.
- Terminal Clause: If the unliquidated assets still cannot be sold by the expiry of the Dissolution Period, they must be mandatorily distributed in-specie to the investors. No further extensions or liquidation windows are permitted under the regulations.
- Certificate Surrender: Upon successful winding-up, the Certificate of Registration of the AIF must be formally surrendered to SEBI.
5.18 The Investor Charter
To ensure ease of reference and protect investor interests, SEBI mandates that all Category III AIFs publish a structured Investor Charter.
Key Disclosures in the Investor Charter
The Investor Charter must include the following structural disclosures:
- Vision and Mission: Clear statements defining the long-term vision and operational mission of the fund.
- Services Provided: Comprehensive details of services provided to unitholders, including:
- The formal process for onboarding and subscription.
- The mechanism to obtain investor consent for material changes to the fund's investment style or structure.
- The timelines and modes for disseminating the fund’s financial statements and portfolio reports.
- Detailed disclosures regarding the material risks associated with alternative investments.
- Grievance Redressal Mechanism: A step-by-step guide explaining how investors can file complaints, along with the designated timelines for resolution.
- Timeline Mandate: The Investment Manager must redress investor grievances promptly and no later than 21 calendar days from the date of receiving the complaint.
5.19 Compliance Test Reporting (CTR)
The Compliance Test Report (CTR) is a mandatory regulatory document that the Investment Manager of a Category III AIF must prepare at the end of each financial year. It serves as a comprehensive self-assessment tool to verify compliance with all SEBI regulations and circulars.
5.19.1 Timeline and Approval Workflow
| Step | Responsible Party | Action | Timeline |
|---|---|---|---|
| 1 | Manager | Prepares and submits the Compliance Test Report (CTR) to the Sponsor and Trustee | Within 30 days of financial year-end |
| 2 | Sponsor / Trustee | Reviews the CTR and sends comments/observations to the Manager | Within 30 days |
| 3 | Manager | Incorporates the comments/changes and finalises the CTR | Within 15 days |
| 4 | Sponsor / Trustee | Reports any unresolved violations to SEBI | Immediately |
- Preparation and Submission: The Investment Manager must prepare and submit the CTR to the Sponsor and the Trustee within 30 days from the end of the financial year.
- Sponsor/Trustee Review: The Sponsor and Trustee must review the report and communicate their observations, comments, or objections to the Investment Manager within 30 days of receiving the CTR.
- Manager Rectification: The Investment Manager must incorporate all necessary changes and address the observations within 15 days from the date of receiving comments from the Sponsor or Trustee.
- SEBI Escalation: Any material compliance violation observed by the Sponsor or Trustee during this process must be reported to SEBI at the earliest.
5.19.2 Key Components of the Compliance Test Report (CTR)
The table below outlines the core components, regulatory benchmarks, and disclosure validations that must be incorporated into the CTR under SEBI guidelines:
Table 5.2: Detailed CTR Disclosure Items and Benchmarks
| CTR Disclosure Item | Regulatory Guidelines & Benchmarks | Verification and Disclosure to be Made in CTR |
|---|---|---|
| Minimum Scheme Corpus | Every scheme launched must maintain a minimum corpus of Rs. 20 crore. | Confirm whether each scheme of the Category III AIF maintained the minimum corpus, and specify any breaches and rectification timelines. |
| Sponsor/Manager Continuing Interest | The Sponsor or Manager must maintain a continuing interest ("skin-in-the-game") of 5% of the corpus or Rs. 10 crore, whichever is lower. | State the exact amount of contribution made by the Sponsor/Manager and confirm that this interest was not reduced, transferred, or withdrawn after the first close. |
| Investment Disclosures | The Sponsor and Manager must disclose their investments in the scheme to all investors. | Verify that all Sponsor/Manager holdings and transaction terms were transparently disclosed to all other investors. |
| Investor Concentration Limit | A Category III AIF scheme is capped at a maximum of 1000 investors. | Disclose the total number of unitholders participating in each scheme, and confirm compliance with the 1000-investor cap. |
| Fund-Raising Route | Category III AIFs can raise funds strictly through a private placement mechanism. | Confirm that the scheme did not make any public invitations or advertisements, and specify the exact private placement channels used. |
| PPM Disclosures | The PPM must contain all material disclosures in accordance with SEBI’s standardized template. | Verify that the PPM contains all mandatory sections (fees, strategy, risks, conflict resolution, disciplinary history, and fee illustrations). |
| Dematerialisation of Units | All Category III AIF schemes must issue units in dematerialised form. | Confirm that all units issued to investors are dematerialised and that the transfer mechanism is reported in the PPM. |
| General Investment Conditions | Strict adherence to SEBI rules on overseas investments, co-investments, concentration limits, and associate transactions. | Verify compliance with: * Maximum 10% concentration limit in a single investee company (cost basis).* Overseas investment caps (25% of investible funds limit).* Prior investor consent (75% vote by value) for transactions with Associates. |
| Valuation Methodology | Portfolio assets must be valued based on standard accounting rules, independent of the fund management team. | Verify that NAV calculation is independent, and confirm that unlisted/listed debt securities were valued by an independent registered valuer. |
| Extension of Fund Tenure | Fund tenure can be extended up to 2 years (1+1) subject to approval by two-thirds (66.67%) of investors by value. | Verify whether any extension was sought, and confirm that the required two-thirds investor approval by value was obtained. |
| Winding-Up and Asset Liquidation | Winding-up must follow standard liquidation or Dissolution Period guidelines. | Verify that the fund obtained 75% investor consent by value for either distributing unliquidated assets in-specie or selling them to a Liquidation Scheme. |
Key Terms and Concepts for Exam Prep
Pari-Passu Rights
The legal principle ensuring that all investors in an AIF scheme are treated equally in proportion to their capital commitments, with identical rights regarding investment allocations, profits, and losses.
Pro-Rata Share
A proportional allocation of assets, liabilities, expenses, or losses based on the ratio of an individual investor's commitment to the total corpus of the scheme.
Dissolution Period
A regulatory period, not exceeding the scheme's original tenure, allowed for the orderly liquidation of unliquidated portfolio investments. It requires 75% investor approval by value.
Compliance Test Report (CTR)
An annual compliance report prepared by the Investment Manager and reviewed by the Sponsor and Trustee to verify adherence to all regulatory guidelines.
Standard Setting Forum for AIFs (SFA)
An industry-led body responsible for formulating standardized implementation guidelines, such as those governing the issuance of differential rights to investors.
💡 Quick Revision Nudge
- Winding-Up Approval: Requires a resolution passed by 75% of the investors by value of their investment.
- Dissolution Period: Requires 75% investor approval by value; the period cannot exceed the original tenure of the scheme and cannot be extended.
- Differential Rights (LVFs): Exempt from pari-passu requirements post-December 13, 2024, subject to PPM disclosure and signed investor waivers.
- CTR Timelines: Manager submits to Sponsor/Trustee within 30 days of financial year-end; Sponsor/Trustee provide comments within 30 days of receipt; Manager rectifies within 15 days of receiving comments.
- Investor Grievance Resolution: Must be redressed by the Manager within 21 calendar days.