SME and Venture Capital AIFs: How They Work and What Risks to Weigh

Category I covers funds that enjoy certain incentives from SEBI or the government, including venture capital funds, SME funds, social venture funds and infrastructure funds. The category exists because these funds invest in areas SEBI considers economically or socially beneficial. In return, they face conditions on how they invest. Category I funds are not allowed to use leverage at the portfolio level.

A venture capital fund is an AIF that primarily invests in unlisted securities of start-ups, emerging or early-stage venture capital undertakings in areas such as new products, services, technology, intellectual property or business models.

In practice, the fund raises commitments from investors, draws the money down over time, invests in a portfolio of young companies, and returns capital when those companies are sold, merge or list. This usually takes several years.

An SME fund focuses on small and medium enterprises. It invests in unlisted companies and in companies listed on or planned for the SME segments of the exchanges. Gains come from growth in the business, a listing, or a later sale. Funds investing in SME exchange-listed firms are exempt from certain insider trading provisions under the relevant ICDR chapter. Check the specifics in the fund’s PPM. 

Angel funds have a new framework. They are now a distinct Category I AIF rather than a sub-category of venture capital funds, and they can onboard only accredited investors. Existing angel funds were given until September 8, 2026 to align with the new regime, and a new fund needs at least five accredited investors before its first close. If you are considering an angel fund, confirm your accredited investor status and the fund’s compliance.

The risks to weigh

1. Illiquidity. These funds are typically closed-ended and invest in unlisted companies. You may not be able to exit for many years.
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3. Failure rates. Early-stage companies fail often. A VC portfolio typically depends on a small number of winners to carry the whole fund.
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5. Valuation uncertainty. Unlisted holdings are valued by judgment, not market price. Reported gains may not be realised.
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7. The J-curve. Fees are charged from the start, while returns come late. Early reported returns are usually negative.
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9. Concentration. A fund with a small number of holdings can swing sharply on one outcome.
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11. Exit dependence. Returns depend on IPOs, acquisitions or secondary sales. If the market for those closes, exits get delayed.
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13. SME-specific risks. Smaller companies may have thinner governance, limited disclosure and lower trading liquidity after listing.
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15. Fees and carry. See our article on AIF costs. Check what the fund charges on committed capital and when carry applies.
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What to check before investing

• Track record: Can the manager show realised exits and DPI, not just valuations?
• Strategy fit: Is the fund stage- and sector-focused or a generalist?
• Portfolio construction: How many companies, what reserve for follow-on investments?
• Fund life: What is the tenure and are extensions possible?
• Valuation policy: Who values holdings, how often and how?
• Your own plan: Can you afford to lock this capital up and still meet your needs?
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Disclaimer: This article is for general information only and is not investment advice. Investments in AIFs are subject to market risks, including loss of capital, and past performance is not indicative of future results. Please read the PPM and consult your advisor before investing.