Going both by value and number of funds, the Category II AIFs surpasses both Category I and III in popularity. Of the 268 funds registered with SEBI as on November 15, 2016, 147 belonged to Category II.
SEBI defines category II as, “Those AIFs, which do not fall in Category I and III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements fall under Category II of AIFs.”
Simply put, category II funds invest in unlisted companies having sound business model by raising funds from HNIs and FPIs through private equity, debt funds, etc. There are various types of funds under this category such as real estate funds, private equity funds (PE funds), funds for distressed assets, etc.
Investment restrictions for Category II:
- Funds in this category can only invest in unlisted companies or in units of other AIFs. The fund usually specifies investment philosophy in the placement memorandum, a document similar to SID of MFs.
- They can also invest in units of venture capital funds, infrastructure funds and hedge funds of AIFs except Funds of Funds.
- These funds cannot borrow funds, except to meet temporary requirements. A category II fund can borrow money only for 30 days and not on more than four occasions in a year. The borrowed amount must not be more than 10% of its investible funds.
- These funds can engage in hedging.
- These funds can invest in unsubscribed portion of an IPO by entering into an agreement with merchant banker.
- SEBI has exempted these funds from Insider Trading Regulations only if the fund invests in Small Medium Enterprises listed on SME exchange. However, these funds will have to hold such securities at least for a year.
Key themes under the AIF regulations
- Continuing Interest: The AIF regulations require the sponsor or the manager of an AIF to contribute a certain amount of capital to the fund. This portion is known as the continuing interest and will remain locked-in the fund until distributions have been made to all the other investors in the fund. For a Category II AIF, the sponsor or the manager is required to have a continuing interest of 2.5% of the corpus of the fund or Rs.50 million whichever is lower.
- Tenure: Category II AIFs can only be closed-end funds. The AIF Regulations prescribe the minimum tenure of 3 years for Category II AIFs. SEBI has clarified that the tenure of any scheme of the AIF must be calculated from the date of the final closing of the scheme. Further, the tenure of any AIF can be extended only with the approval of 2/3rd of the unit-holders.
Taxation for category II funds is similar to debt funds. This means, while Short Term Capital Gain (STCG) is taxed at marginal rate of taxation i.e. 30% (HNIs come under highest tax bracket), Long Term Capital Gain is taxed at 20% with indexation benefits. LTCG is applicable if investor redeems their investments after two years.
AIFs typically offer an upfront commission in the range of 2% to 3% to distributors depending on the type of AIF. However, the structure and quantum may vary from fund to fund.