Private Credit Funds in India: How Category II AIFs Work, Key Risks

Introduction

You might have heard about Cat 2 AIFs and private equity. But here’s what you didn’t know!

Many High-Net-Worth Individuals (HNIs) are exploring Private Credit AIFs for portfolio diversification and income opportunities. 

With India's private credit market crossing $12.4 billion in deal value across 166 transactions in CY2025, the hype around private credit funds in India stays. 

But remember, they don’t invest like listed bonds or debt mutual funds.

In this guide, we'll explain how private credit funds work, the key risks investors should assess, and the checklist investors should use to evaluate Private Credit AIFs.

Keep reading further!

What are Private Credit AIFs & Why Are They Growing in India?

A Private Credit AIF is typically a Category II Alternative Investment Fund that invests in privately negotiated debt or credit instruments issued by businesses. 

Instead of lending through traditional banks, private credit funds provide capital directly to 15-20 borrowers and try to generate returns through interest income, repayment structures, and credit opportunities. 

Hence, before investing, private credit fund investors should evaluate borrower quality, credit risk, liquidity, fund strategy, and the manager's underwriting process.

Why Private Credit Is Growing in India?

Private credit has gained traction in India as businesses increasingly seek financing options beyond traditional bank loans. 

At the same time, investors are looking to diversify beyond conventional equity and fixed-income investments. This shift has created opportunities for Private Credit to play a growing role in corporate financing and portfolio diversification.

Key reasons why Private Credit Funds are growing:

• Channeling into Cat 2 AIFs -

  Since AIFs do not follow the same regulatory framework as traditional lenders, they can offer flexibility such as step-up interest rates, bullet repayments, equity warrants, convertible features, etc., in debt financing. Also, there is tax efficiency achievable in Category 2 AIF (depending on income type).  

• Flexibility in investments 

  In mutual funds, investing in unlisted NCDs is allowed only up to 10% of the debt portfolio. As a result, it gives an added advantage to Cat 2 AIFs. 

• Bank risk aversion 

  On a ground level, banks are not actively lending to a large section of the economy. Hence, industries are increasingly leaning on non-traditional methods, raising credit from the likes of AIFs. 

• Promoter funding gaps 

  Promoters expanding businesses, funding acquisitions, or bridging cash-flow mismatches need capital faster than banks can approve. Private credit funds close in 4–8 weeks versus 3–6 months for banks.

Approximately 35% of private credit deals involve M&A financing. 

• Foreign capital entry. 

  Global private credit managers (Ares, Oaktree, KKR Credit) are deploying into India through AIF structures, bringing institutional capital and underwriting standards alongside domestic players.

How Private Credit Funds are Structured?

The majority of private credit funds in India are structured as Category II Alternative Investment Funds under SEBI's AIF Regulations, 2012, as;

Performing Credit (Direct Lending)

Structured / Mezzanine Credit (hybrid of debt and equity features)

Special Situations and Distressed Credit (lending to companies in financial stress — restructuring, insolvency, or turnaround situations)

Real Estate Credit (lending to developers against project assets)

Venture Debt (lending to late-stage startups alongside or after equity funding rounds)

Category 2 AIF is a close-ended, pass-through vehicle that cannot use leverage (except for operational needs). It must appoint an independent custodian and distribute income directly to investors with tax pass-through under Section 115UB.

Key Features of Private Credit AIF:

Private credit funds use Category II because it offers the right combination of structural constraints and tax treatment, like:

• No leverage 

  Category II AIFs cannot borrow except for day-to-day operational requirements (max 30 days). This protects investors from amplified losses.

• Close-ended structure 

  Investors commit capital upfront. The fund has a defined tenure (3–6 years) with no open-ended redemptions.

• Pass-through taxation 

  Income is taxed in the investor's hands, not at the fund level (unlike Category III, which is taxed at the maximum marginal rate at the fund level).

• No minimum holding period 

  Unlike Category I, which requires specific investment mandates, Category II offers strategy flexibility within the debt/credit universe.

The Fund Lifecycle: How is your money invested in Private Credit AIF?

Investment in Cat 2 AIF happens in 6 steps or cycles. Here’s the breakdown:

Commitment 

As per SEBI regulations, investment of ₹1 crore is mandatory in Alternative Investment Funds. But the fund doesn't necessarily take it all upfront.

Drawdown 

As the AIF fund finds deals, it "calls" capital in tranches (typically over 12–24 months). You receive drawdown notices and must transfer the called amount within the stipulated period.

Deployment

The fund lends to borrowers against security (real estate, receivables, corporate guarantees, share pledges). Deals are structured with covenants, repayment schedules, and enforcement mechanisms.

Repayment 

Borrowers repay principal and interest per the agreed schedule. The fund collects cash flows.

Distribution 

The fund distributes collected cash flows to investors (typically quarterly or semi-annually). Private credit fund distributions may include interest income, principal repayment, and (at maturity) return of remaining capital.

Who can invest in Private Credit AIF? 

Any Indian resident, HUF, NRI, or institutional investor can invest in a private credit AIF, subject to;

•  SEBI's minimum AIF commitment of ₹1 crore per investor per scheme
• Completion of KYC and accredited investor documentation
• Fund tenure is typically 3–5 years, with a 1–2 year extension at the manager's discretion

How Private Credit Funds Are Taxed In India?

Since Private Credit funds fall under the CAT 2 AIF umbrella, the taxation is pass-through income in the investor's hands under Section 115UB of the Income Tax Act. 

• Interest income: 

  Taxed as "Income from Other Sources" at your slab rate. For most HNIs, this is 30% plus surcharge and cess (effective rate). 

• Capital gains (if any): 

  If the fund sells debt instruments before maturity, gains are taxed as STCG (at slab rate if held <3 years) or LTCG (at applicable rates for the instrument type).

• TDS: 

  The fund deducts TDS at 10% on income distributions. You claim credit for TDS paid when filing your ITR.

• Pass-through, not exempt: 

  Unlike equity AIF Category III (taxed at fund level), Category II passes income through to you. You report it. You pay tax on it.

(Note: Tax laws are subject to change. Consult a qualified tax advisor for guidance specific to your situation.)

Key Risks in Private Credit AIFs

Private credit AIFs carry seven distinct risks that investors must evaluate individually.

• Credit default (borrower doesn't repay)
• Illiquidity (capital locked for years)
• Valuation opacity (NAVs based on models, not markets)
• Concentration (too few borrowers)
• Enforcement risk (recovery through Indian courts can take 2–5 years).

Final Thoughts

Private Credit AIFs can provide access to opportunities beyond traditional debt markets, but they also involve risks that require careful assessment. 

That’s where consulting an AIF provider can help you analyze the options and make a better choice for you. 

Rather than focusing solely on potential yields, one should evaluate the fund's credit underwriting process, liquidity terms, diversification, others, and how it aligns with their overall portfolio objectives.