AIF leverage rules: meaning, how they work in India and examples

Leverage means using borrowed money, or contracts that act like borrowed money, to take a bigger position than the fund's own capital would allow. A fund with ₹100 crore of investor money that also borrows ₹100 crore has twice as much money at work. If the bets win, the gains are larger. If they lose, the losses are larger too, and the loan still has to be repaid.

In India most private funds are set up as Alternative Investment Funds, or AIFs, under the SEBI (Alternative Investment Funds) Regulations, 2012. The regulator, the Securities and Exchange Board of India (SEBI), sorts AIFs into three categories and treats leverage very differently in each. A venture capital fund and a hedge fund can both be AIFs, yet one is nearly barred from borrowing and the other is allowed to.

Category I AIFs back sectors the government wants to encourage: venture capital funds, angel funds, social venture funds and infrastructure funds. Category II AIFs are the broad middle group, such as private equity and debt funds, that do not fall in the other two categories and do not use leverage beyond what the rules allow. Category III AIFs use varied or complex trading strategies, and include hedge funds and some long-short or arbitrage funds.

The leverage rules follow this split. The more a fund looks like a long-term investor in private companies, the tighter the borrowing limits. The more it looks like a trading fund, the more room SEBI gives it, but with a ceiling.

Not for investing. The AIF Regulations bar Category I and II funds from borrowing, directly or indirectly, or using leverage, except to meet temporary funding needs. Law-firm summaries of the rules say such borrowing may not last more than thirty days, may not happen more than four times in a year, and may not exceed ten per cent of the fund's investable funds.

SEBI added detail in a circular of 19 August 2024. According to summaries of that circular, a fund may borrow to cover a temporary gap when investors have not yet paid in a called amount, and the borrowing is capped at the lowest of three measures: 20 per cent of the proposed investment, 10 per cent of the scheme's investable funds, or the commitment still pending from investors. A cooling-off gap of thirty days is needed between two borrowings. Only secondary summaries were checked here, so the circular itself should be read for the full conditions.

• Purpose: bridge a delay in investor drawdowns, not add risk.
• Duration: up to 30 days at a time.
• Frequency: up to four times a year.
• Size: capped by the percentage limits above.
• Gap: 30 days between two borrowings.

A venture capital fund invests in young companies that may take eight to ten years to return money, and many will return nothing. A loan has a fixed repayment date and interest. Mixing the two could force a fund to sell holdings early, or leave it unable to repay if the portfolio stays illiquid. SEBI's rule removes that risk by keeping the fund funded by its investors' commitments.

Those commitments are the way a fund gets its money. Limited partners, the investors, promise a sum and the manager calls it in pieces. The short-term borrowing window exists only because a call can be paid late. The fund borrows for a few weeks, makes the deal on time, then repays the bank when investors pay in.

A Category III AIF may use leverage, but within a cap. SEBI's 2013 circular on the subject, as described in law-firm notes, limits the leverage ratio to two times the fund's net asset value (NAV), measured as total exposure divided by NAV on a netted basis. NAV is the value of the fund's assets minus what it owes.

So a Category III fund with ₹100 crore of NAV can, under this cap, run exposure of up to ₹200 crore. The fund must also follow rules on disclosure, risk management and how exposure is measured. A fund's offering document, called the private placement memorandum, states which strategy and what leverage the fund will use. Details can be changed by later circulars, so the current text should be checked.

Leverage multiplies outcomes in both directions. Take a Category III fund with ₹100 crore of net asset value that runs exposure of ₹200 crore. If its positions rise 5 per cent, the exposure gains ₹10 crore, which is a 10 per cent gain on the fund's own capital. If the positions fall 5 per cent, the fund loses 10 per cent of its capital. A fall of 50 per cent in the positions would, in this simple picture, wipe out the entire fund.

This is why lenders and regulators watch leverage closely. Borrowed positions may need extra cash when prices fall, and a fund that cannot meet such a call may have to sell at a bad moment. Funds that hold private companies, which cannot be sold in a day, would be hurt far more by such forced selling, and that is the reasoning usually given for keeping Category I and II funds away from leverage.

The rules cover indirect leverage as well as plain loans. Derivative positions, margin funding and some guarantees can add exposure without a bank loan. That is why SEBI speaks of total exposure for Category III funds rather than only the amount borrowed.

Borrowing by the companies a fund owns is a different matter. A portfolio company may take a bank loan or venture debt without breaking any AIF rule, because the debt sits in the company, not the fund. The limits apply to the fund's own balance sheet.

Investors in a fund, called limited partners, can read the offering document to see whether the fund may borrow and how much. Useful questions are simple. Does the fund plan to use any leverage at all? Is borrowing meant only to bridge drawdowns? How is exposure measured, and who checks it? How often is the figure reported?

Answers should match the category. A venture fund that talks about regular borrowing for investments would not fit the rules as summarised above. A Category III fund that does not state its leverage limit in the document leaves investors guessing. Limited partners in India include family offices, wealthy individuals and institutions, and they usually ask these questions during the fund's first close.

When a headline says a fund raised debt, check who borrowed. If a venture fund is said to have taken a loan, the likely explanation is a short bridge for a drawdown gap. If a startup raised venture debt, that is the company's loan and has nothing to do with these limits.

Investors also use the limits to judge risk. A Category III fund running near its two-times cap can swing sharply in both directions. A Category I or II fund has no such amplifier, so its returns come from the quality of its investments and the time it holds them. This guide is general information, not legal, tax or investment advice, so check the current SEBI text with a professional before acting.