NISM-Series-X-A: Investment Adviser (Level 1) · Overview of Alternative Investment Funds (AIFs)

Categories of AIFs: Category I, II and III Explained

Updated 11 October 2026 · Fact-checked

SEBI splits Alternative Investment Funds into three categories. Category I funds invest in sectors the economy wants to encourage, such as start-ups, SMEs, social ventures and infrastructure. Category II funds do not fit I or III and do not use leverage except to meet day-to-day needs. Category III funds use complex or leveraged trading strategies.

Understand Categories of AIFs (Category I, II and III)

An Alternative Investment Fund (AIF) is a privately pooled investment vehicle set up in India and regulated by SEBI under the SEBI (Alternative Investment Funds) Regulations, 2012. It collects money from Indian or foreign investors and invests it as per a defined investment policy. SEBI sorts AIFs into three categories based on what they invest in and how much risk or leverage they use.

Category I AIFs invest in start-ups, early-stage ventures, social ventures, SMEs, infrastructure or other sectors that the government or regulators consider socially or economically desirable. Sub-types are venture capital funds, SME funds, social venture funds, infrastructure funds and other AIFs such as angel funds. SEBI or the government may offer incentives or concessions to this category.

Category II AIFs are the residual category. They do not fall under Category I or III and do not undertake leverage or borrowing other than to meet day-to-day operational requirements, within limits set in the regulations. Typical examples are private equity funds, debt funds and funds of funds. No specific incentives or concessions are given.

Category III AIFs employ diverse or complex trading strategies and may use leverage, including investing in listed or unlisted derivatives. Examples are hedge funds and PIPE funds (private investment in public equity). They aim for short-term returns and no concessions are given. Category III funds can be open-ended, while Category I and II funds are close-ended.

A simple way to remember it: Category I helps the economy, Category II is plain private capital without leverage, and Category III is trading-driven and leveraged.

Key formulas to remember

Category I AIF: Start-ups, early stage, SMEs, social ventures, infrastructure → VC, SME, social venture, infrastructure funds; Invests in sectors seen as socially or economically desirable. Government or regulators may give incentives. Close-ended.
Category II AIF: Residual category → private equity, debt funds, fund of funds; Does not fit I or III. No borrowing except for day-to-day operational needs, within regulatory limits. No specific concessions. Close-ended.
Category III AIF: Diverse or complex trading strategies, may use leverage → hedge funds, PIPE funds; May invest in listed or unlisted derivatives. Can be open-ended or close-ended. No concessions.
Key contrast: Leverage: Cat I and II = no (except day-to-day needs, within limits) | Cat III = yes, permitted; This is the most tested difference between Category II and Category III.

How to solve Categories of AIFs (Category I, II and III) questions

Most questions give a fund description and ask for its category, or give a category and ask for a feature. Work from the investment objective and the use of leverage.

1Read the question and note the fund type or feature named.
2Ask: does the fund target start-ups, SMEs, social impact or infrastructure? If yes, it is Category I.
3Ask: does it use leverage, derivatives or short-term trading strategies? If yes, it is Category III.
4If it is private equity, debt or fund of funds with no leverage, it is Category II.
5Check the structure: Category III may be open-ended; Categories I and II are close-ended.
6Check for incentives: only Category I may attract concessions from government or regulators.
7Eliminate options that mix features from different categories, then choose the best fit.

Quickest way: Three-question category test

When to use it: Use for any one-line MCQ that names a fund or a feature and asks for the category.

Impact or priority sector (start-up, SME, social, infrastructure)? Pick Category I.
Leverage or trading strategies (hedge, PIPE)? Pick Category III.
Private equity, debt fund or fund of funds? Pick Category II.
If the question mentions open-ended, think Category III; if it mentions concessions, think Category I.

Common mistakes in Categories of AIFs (Category I, II and III)

Placing private equity funds in Category I because they invest in unlisted companies.
Venture capital and private equity both invest in unlisted companies, so they look alike.
Fix: Venture capital is Category I. Private equity is Category II. Think: VC backs start-ups, PE is the residual group.
Saying Category II funds can use leverage freely.
Students confuse Category II with Category III.
Fix: Category II may borrow only to meet day-to-day operational needs, within limits. Free use of leverage and derivatives is a Category III feature.
Treating hedge funds as Category II.
Hedge funds are also privately pooled, so they seem to belong to the residual group.
Fix: Hedge funds use complex strategies and leverage, so they are Category III, as are PIPE funds.
Believing all AIFs must be close-ended.
Categories I and II are close-ended, and students generalise.
Fix: Category III funds can be open-ended or close-ended.
Thinking every AIF category gets government incentives.
The word 'concessions' is linked to AIFs in general.
Fix: Only Category I may get incentives or concessions. Categories II and III get none.

Worked examples

Example 1

A fund pools money from investors and invests in early-stage start-ups. It does not use leverage. Under SEBI AIF rules, which category does it belong to?
A. Category I
B. Category II
C. Category III
D. It is not an AIF

Show the solution

The fund targets start-ups, which is a sector the economy wants to encourage.
That points to Category I, specifically a venture capital fund.
Category II is the residual group and Category III uses complex strategies; neither matches.
It is a privately pooled fund, so it is an AIF.

Answer: A. Category I

Example 2

Which statement about Category III AIFs is correct?
A. They invest only in start-ups and receive government incentives.
B. They employ diverse or complex trading strategies and may use leverage.
C. They must be close-ended and cannot invest in derivatives.
D. They are the residual category and cannot borrow at all.

Show the solution

Option A describes Category I.
Option B matches the Category III definition: complex strategies and permitted leverage, including derivatives.
Option C is wrong because Category III can be open-ended and may invest in derivatives.
Option D describes Category II, which is the residual group.

Answer: B. They employ diverse or complex trading strategies and may use leverage.

Exam tips

Memorise one example per category: venture capital for I, private equity for II, hedge fund for III.
The Category II versus III split is usually tested on leverage and derivatives, so read for those words.
Watch for 'open-ended': it points to Category III only. Categories I and II are close-ended.
In X-A, wrong answers carry negative marking of 25% of the marks for the question, so if two options mix categories, eliminate them first and then guess.

Practice questions from Overview of Alternative Investment Funds (AIFs)

Categories of AIFs (Category I, II and III): frequently asked questions

What is the difference between Category II and Category III AIF?

Category II is the residual group, such as private equity and debt funds. It does not borrow except for day-to-day needs, within limits. Category III uses complex or leveraged trading strategies and may invest in derivatives, as hedge funds do.

Is a venture capital fund Category I or II?

A venture capital fund is a Category I AIF. It invests in start-ups and early-stage businesses, which regulators wish to encourage. Private equity funds are in Category II.

Which AIF category are hedge funds and PIPE funds in?

Both are Category III AIFs. They follow trading-oriented strategies and can use leverage. They aim at shorter-term returns and receive no concessions.

Which AIFs can be open-ended?

Only Category III AIFs can be open-ended or close-ended. Category I and Category II AIFs are close-ended.