Term Sheet Defects in a New Open-Ended Category III Fund
Arka Capital is drafting the term sheet for its first Category III AIF. The fund will have a ₹60 crore corpus, 120 investors and an open-ended structure with monthly redemptions. The minimum commitment is set at ₹50 lakh for ordinary investors and ₹25 lakh for two employees of the manager. The strategy will run 70% of assets in listed derivatives and 30% in cash equities, with target leverage of 2.5 times NAV. The manager plans to publish NAV monthly and to allow redemptions with 10 days' notice. Its compliance officer flags that the term sheet may not be compliant and asks whether the fund can retain the open-ended monthly redemption feature if the derivatives book is illiquid. The investment team argues that Category III AIFs are allowed to use leverage and complex strategies, so the structure should be approved as drafted.
1. Identify the regulatory defects in the proposed term sheet and explain the consequence for each.
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Defects and consequences
- Minimum commitment: Ordinary investors must commit at least ₹1 crore. ₹50 lakh is not permitted; ₹25 lakh is available only to employees/directors of the manager. The two employee commitments can stand, but the ordinary-investor minimum must be raised.
- Leverage: A 2.5x target exceeds the 2x NAV ceiling for Category III. The strategy must be capped at 2x, with a buffer for NAV movements.
- Open-ended monthly redemption: Category III AIFs may be open-ended, but monthly redemption is not automatically invalid. It is only workable if the portfolio is sufficiently liquid and the fund can pay redemptions without fire sales. A 70% derivatives book can be liquid, but the term sheet must disclose redemption frequency, notice, gates/suspension and valuation.
- Corpus/investors: ₹60 crore exceeds the ₹20 crore minimum, and 120 investors are within the permitted range.
Conclusion: the term sheet cannot be approved as drafted. Minimum commitment and leverage must be corrected, and redemption terms must be justified by a liquidity stress test.
2. Advise how Arka can restructure the fund to remain a Category III AIF while meeting investor liquidity expectations.
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Restructuring options
Arka should first decide whether the fund genuinely needs monthly liquidity. If it retains open-ended status, it should: (i) set the ordinary minimum at ₹1 crore; (ii) cap leverage at 2x with an internal trigger at 1.8x; (iii) hold a liquidity buffer and run stress tests for a 20-30% redemption; (iv) disclose that redemptions may be suspended/gated in exceptional conditions; and (v) value derivatives daily and publish NAV at the disclosed frequency. If the derivatives book is illiquid or margin-intensive, a close-ended or lower-frequency redemption structure is safer. A close-ended fund can still use Category III strategies, but investors accept lock-in. Arka should also disclose that Category III strategies carry higher risk, leverage can magnify losses, and derivative income may be business income at the fund level, not necessarily pass-through. The manager should not promise monthly liquidity merely to market the fund; the redemption profile must match the strategy's liquidity.
3. Explain why Category III treatment changes the risk and tax disclosure compared with Category I and II AIFs.
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Category III is the residual, most flexible category: it may use complex trading strategies and leverage through listed/unlisted derivatives. That flexibility comes with stronger risk controls, leverage monitoring and investor disclosure. Unlike Category I/II, Category III can be open-ended and can run long-short and derivative strategies; it is not a pass-through-for-all-income vehicle, because business income including derivative trading can be taxed at the fund level. Investors therefore need clear disclosure of leverage, valuation, liquidity and tax. The compliance officer should treat the term sheet as a risk-disclosure document, not just a marketing document.