When an Alternative Investment Fund (AIF) exits an investment, the proceeds do not flow to investors and fund managers in any order they choose. A contractual sequence in the Private Placement Memorandum (PPM) and the Limited Partnership Agreement (LPA) governs exactly who gets paid first, how much, and under what conditions. That sequence is the distribution waterfall. Getting it wrong does not just affect fund economics. Since the Securities and Exchange Board of India (SEBI)’s November 2024 amendments to the AIF Regulations 2012, a non-compliant waterfall can prevent a fund from accepting fresh commitments or making new investments. This guide covers the full mechanics of AIF distribution waterfalls, the regulatory framework after the 2024-25 SEBI overhaul, how different waterfall structures compare, and what the Budget 2025 capital gains clarification means for carried interest taxation.
What is a distribution waterfall in an AIF?
A distribution waterfall is the contractually defined sequence in which proceeds from investment exits are allocated between investors (limited partners or unit holders) and the investment manager (the carry-receiving party) in an AIF scheme. It is disclosed in the fund’s PPM under the mandatory Part A template prescribed by SEBI’s Master Circular for AIFs dated 03/06/2026 (which superseded the previous Master Circular dated 07/05/2024 and consolidates all circulars issued up to 31/05/2026), and it must include a worked numerical illustration. Without a clearly drafted waterfall, SEBI will raise queries during PPM review, and inconsistencies between the PPM and the LPA/contribution agreement are one of the most common triggers for post-registration enforcement action.
How the four-tier waterfall structure works in an Indian AIF
Every AIF distribution waterfall in India runs through the same four sequential tiers. The tiers must be satisfied in full before any proceeds move to the next level. The specific parameters (hurdle rate, carry percentage, catch-up mechanics) are fixed in the PPM and cannot be varied after filing without a material amendment process.
Tier 1: Return of contributed capital
The first claim on any exit proceeds is the full return of capital contributed by investors. This includes both the drawn-down capital deployed into the exited investment and any fund expenses or management fees charged against the investor’s account. Capital must be returned at cost, with no mark-up for unrealised appreciation. Only once contributed capital is fully returned do proceeds flow to Tier 2. This tier protects investors from receiving performance distributions before their principal is recovered.
One frequently misunderstood point: the “capital” in Tier 1 is the drawn-down capital net of management fees already deducted at fund level. Management fees charged by the investment manager during the investment period reduce the fund’s investable corpus (and therefore the amount that enters the waterfall) before any exit occurs. A fund raising ₹200 crore that charges a 2% annual management fee over a four-year investment period will have consumed approximately ₹16 crore in fees before the first exit, leaving ₹184 crore as the actual deployed capital base for waterfall purposes. This is not an error in the waterfall; it is how the economics are designed. LPs who model waterfall returns using the gross ₹200 crore commitment as the capital base will overstate their expected return.
A related operational point: all new AIF investments made on or after 01/07/2025 must be held in dematerialised form under SEBI Circular SEBI/HO/AFD/PoD/CIR/2024/5 dated 12/01/2024. Exit proceeds from demat-held securities flow through the clearing settlement mechanism before reaching the fund’s bank account, which adds one to two settlement days between the exit event and the date on which the waterfall can be run. Fund administrators must account for this in distribution timing disclosures to investors.
Tier 2: Preferred return (hurdle rate)
Once capital is returned, investors receive a minimum annualised return on their investment before the manager participates in profits. This threshold is called the hurdle rate or preferred return. In Indian Category II AIFs focusing on private equity or growth equity, the most common hurdle is 8% per annum. Category II structured credit and private debt AIFs sometimes set the hurdle at 10% to 12% to reflect higher absolute return targets. The compounding methodology matters materially: a fund that accrues the hurdle on a compound annual basis versus a simple interest basis produces materially different investor payouts on the same capital base. On a ₹100 crore LP contribution held for six years, a simple 8% hurdle produces ₹48 crore in preferred return; at compound accrual, the figure rises to approximately ₹58.7 crore. The PPM must specify which basis applies.
Tier 3: GP catch-up (if applicable)
After the hurdle is paid, many fund structures include a catch-up provision that allows the investment manager to receive a disproportionate share of subsequent distributions until their total carry aligns with the agreed percentage of all profits above the capital return. In a standard 20% carry arrangement, the catch-up operates as follows: the manager receives 100% of distributions after the hurdle until they have received 20% of the total profits distributed to date (capital return plus preferred return plus catch-up). The catch-up is not mandatory. Some funds skip it and pay carry only on returns above the hurdle, which reduces manager compensation at lower return levels but simplifies calculation. The decision is disclosed in the PPM and must match the LPA.
Tier 4: Carried interest on residual profits
After the catch-up, remaining profits are split between investors and the investment manager in the ratio specified in the PPM, most commonly 80:20, meaning investors receive 80% and the manager receives 20% as carried interest. In Indian AIFs, carry is typically 15% to 20% of profits above the hurdle rate, with 20% being the market standard for Category II equity funds. Venture capital funds within Category I sometimes use 20% carry with no hurdle, because the binary nature of early-stage outcomes makes hurdle mechanics less relevant than in buyout or growth equity.
Residual distribution
Any remaining proceeds after Tier 4 are distributed pro-rata to investors in proportion to their commitment or undrawn commitment, depending on which basis the fund specifies under the now-operative Regulation 20(21) framework (discussed below).
Table 1: Standard four-tier waterfall for a Category II equity AIF
| Tier | Recipient | Trigger condition | Typical parameter |
|---|---|---|---|
| 1. Return of capital | Investors | First priority, no condition | 100% of contributed capital |
| 2. Preferred return | Investors | After Tier 1 is satisfied | 8% per annum (compound or simple) |
| 3. Catch-up | Investment manager | After hurdle is cleared | 100% to manager until carry target reached |
| 4. Carried interest | Investment manager | On profits above hurdle and after catch-up | 15%-20% of aggregate profits |
| Residual | Investors | After all above tiers | Pro-rata to commitment |
What is the difference between an American and a European waterfall?
The biggest structural choice in any AIF waterfall is the trigger point for when the investment manager can begin receiving carried interest. This choice, more than the carry percentage itself, determines the distribution of risk and cash flow between investors and the manager.
American waterfall (deal-by-deal)
In a deal-by-deal waterfall, the manager earns carry after each individual exit, provided that specific investment clears the hurdle. The four-tier waterfall runs against the cost basis of that single deal, not against the fund’s aggregate capital. If the fund’s first exit is highly profitable, the manager receives carry immediately, even if other portfolio companies are underperforming or have not yet returned capital. The advantage for managers is liquidity. Emerging and first-time fund managers who cannot sustain operations on management fees alone find the deal-by-deal structure important for cashflow. The risk is that early carry distributions may exceed what the manager is ultimately entitled to once the full portfolio is wound down, creating a clawback obligation.
European waterfall (whole-fund)
In a whole-fund or European waterfall, the manager receives no carry until investors have recovered 100% of their contributed capital across the entire portfolio, plus their preferred return on all deployed capital. Carry is calculated on the fund’s aggregate performance, not on individual deal outcomes. This is substantially more investor-protective: a manager who generates one successful exit and three failures does not receive carry until the losses from the failures are overcome. The European structure is more common in larger Indian PE funds and in institutional-grade Category II structures. It also reduces clawback complexity, since the manager’s carry entitlement is established at fund level rather than deal level.
In India, the PPM must disclose which model applies and illustrate it with a numerical worked example. Deal-by-deal waterfalls are permitted but require a robust clawback mechanism in the PPM to protect investors from overpayment if early exits are followed by losses. For guidance on how to negotiate the waterfall model, clawback terms, and management fee step-downs from the GP’s perspective, see Treelife’s guide to LP agreement essentials for Indian AIF managers.
Table 2: American vs European waterfall compared
| Dimension | American (deal-by-deal) | European (whole-fund) |
|---|---|---|
| When manager earns carry | After each profitable exit | After full portfolio capital recovery |
| LP protection | Lower (clawback dependent) | Higher (structural) |
| Manager liquidity | Earlier | Later, typically at fund end |
| Clawback complexity | High | Low to moderate |
| Typical Indian context | VC and growth equity | Buyout and large PE funds |
| SEBI requirement | Clawback provision mandatory in PPM | No specific SEBI mandate beyond disclosure |
Hard hurdle vs soft hurdle: what Indian funds actually use
The hurdle can be structured in two ways that produce different economics for the manager.
A hard hurdle means the manager earns carry only on returns above the hurdle rate. If the fund delivers a 14% IRR and the hurdle is 8%, the manager earns carry only on the 6% excess. The manager does not retroactively earn carry on the 8% preferred return, even after the catch-up.
A soft hurdle (with catch-up) means the hurdle determines when the manager starts earning carry, not the base on which carry is calculated. Once the hurdle is cleared, the catch-up mechanism allows the manager to effectively receive carry on the entirety of profits above capital return, including the portion equal to the preferred return. This is the more common structure in Indian AIFs because it preserves the full 20% carry economics for the manager while still requiring the hurdle threshold to be crossed first.
A limited catch-up (where the manager receives only 80% to 90% of distributions during the catch-up phase) is occasionally negotiated by institutional LPs. This is still uncommon in the Indian market but has appeared in terms sheets from domestic insurance funds and pension capital.
How does SEBI’s Regulation 20(21) change the distribution waterfall?
This is where many fund managers running existing or planned AIFs are currently at risk of non-compliance, and where the Indian waterfall framework diverges most sharply from global PE norms.
Through the Securities and Exchange Board of India (Alternative Investment Funds) (Fifth Amendment) Regulations 2024, notified on 18/11/2024, SEBI inserted Regulation 20(21) into the AIF Regulations 2012. The regulation states that investors of an AIF scheme shall have rights pro-rata to their commitment to the scheme, in each investment and in the distribution of proceeds of each investment, except as specified by SEBI.
This was a direct regulatory response to the priority distribution model that certain AIFs had been using to attract specific investor classes. Under the priority distribution model, AIFs issued senior and junior (subordinate) unit classes. Senior unit holders received preferential distributions, effectively guaranteed returns before junior holders participated, while junior unit holders, often unrelated to the manager or sponsor, bore disproportionate losses. SEBI had already flagged this structure via its circular dated 23/11/2022, directing such funds to stop accepting fresh commitments. The November 2024 amendment converted that prohibition into a statutory requirement backed by Regulation 20(21).
What is still permitted under Regulation 20(21)
SEBI’s circular dated 13/12/2024, issued to operationalise the November 2024 amendment, sets out specific exemptions from the pro-rata requirement. A waterfall that departs from strict pro-rata is still permissible in three scenarios:
- An investor has been excused or excluded from participating in a specific investment (typically for regulatory or tax reasons applicable to that investor alone).
- An investor has defaulted on their pro-rata drawdown obligation for the relevant investment.
- Returns or profits are being shared with the investment manager or sponsor of the AIF, provided this sharing is documented in the contribution agreement.
This third exemption explicitly permits the standard carried interest structure, where the investment manager receives a disproportionate share of profits through carry, to continue. Carry distributions to the manager are not required to be pro-rata to the manager’s unit holding.
Large Value Funds for Accredited Investors: the structural exemption
Large Value Funds for Accredited Investors (LVFs) are exempt from Regulation 20(22)’s pari-passu requirement. An LVF whose PPM is filed after 13/12/2024 may issue differential rights to investors, provided appropriate disclosures are made in the PPM and each accredited investor provides a written waiver at on-boarding acknowledging the departure from pari-passu. This exemption makes LVFs the appropriate vehicle for sophisticated investor structures that require non-standard distribution mechanics.
What existing priority distribution model funds must do
AIFs that adopted the priority distribution model before 18/11/2024 and are not covered by the exemptions in the December 2024 circular must neither accept fresh commitments nor invest in new companies. AIFs with PPMs filed on or after 01/03/2020 that granted differential rights falling outside the SFA implementation standards were required to report those rights to SEBI on or before 28/02/2025, and to immediately terminate any differential rights found to be adversely affecting other investors.
What does the November 2025 SEBI Draft Circular change?
After the December 2024 framework was issued, operational ambiguities surfaced in applying pro-rata mechanics to live AIF schemes. What does “commitment to the scheme” mean: the full commitment made or the undrawn commitment outstanding? How are excused investors treated for concentration limit calculations? How does the pro-rata test apply to open-ended Category III AIFs?
SEBI’s Draft Circular of 07/11/2025 proposed several clarifications:
- “Commitment to the scheme” for drawdown purposes may be read as either the total commitment or the undrawn commitment, and each scheme must adopt one basis uniformly; it cannot shift between methods.
- Time-weighted distribution mechanics are required to fairly allocate proceeds when investors entered the scheme at different times or in different closing tranches.
- Excused and excluded investors are to be treated in a defined manner for concentration limit calculations, to prevent inadvertent breaches arising solely from exclusion mechanics.
- Open-ended Category III AIFs issuing and redeeming units at NAV must comply with the pro-rata framework differently; distributions follow NAV-based mechanics, and the scheme must specify this in its PPM.
These proposals were open for public comment until 28/11/2025. The final circular had not been issued as of the date of this article; fund managers should verify the current position with SEBI’s website before finalising any PPM amendments.
For a full walkthrough of PPM structure requirements under the SEBI Master Circular, including the mandatory waterfall illustration, see Treelife’s guide to the Private Placement Memorandum for an AIF.
How is carried interest taxed after Budget 2025?
The Finance Act 2025 resolved the long-running characterisation debate for equity-oriented Category I and II AIFs. Effective from AY 2026-27, the definition of “capital asset” under Section 2(14) of the Income Tax Act 1961 was amended to expressly include securities held by these funds as referred to in Section 115UB. Income from their transfer is therefore capital gains, not business income. Since the character of income is preserved under the pass-through regime, carry distributions flowing from realised equity gains are capital gains in the investment manager’s hands. Current rates: LTCG at 12.5% under Section 112A (for listed equity gains above ₹1.25 lakh); STCG at 20% under Section 111A; LTCG on unlisted shares at 12.5% without indexation (all for transfers on or after 23/07/2024, per the Finance (No. 2) Act 2024).
For Category II private debt or structured credit funds where interest income dominates, carry attributable to interest distributions may still flow at the investor’s slab rate; the capital gains clarification does not override the income character of the underlying receipts.
TDS on distributions from Category I and II AIFs to resident investors applies under Section 194LBB at 10% (renumbered as Section 393(1) under the Income Tax Act 2025, effective 01/04/2026). TDS at 10% is a withholding rate only; investors pay advance tax at their applicable effective rate and claim TDS credit accordingly.
For a complete analysis of carry structuring, vesting mechanics, FEMA reporting for resident managers, and documentation to support capital gains characterisation at assessment, see Treelife’s dedicated guide to carried interest in India: structuring and taxation.
What is a clawback provision and how do Indian AIFs structure it?
A clawback provision requires the investment manager to return previously distributed carried interest to investors if, at the end of the fund’s life, the manager has received more carry than its contractual share of total profits. Clawbacks are most relevant under American deal-by-deal waterfalls, where early profitable exits generate carry distributions before the full portfolio is realised.
In Indian AIFs, the PPM must include a clawback mechanism if a deal-by-deal waterfall is used (per SEBI’s registration guidance). In practice, clawback provisions in Indian funds take three forms:
- Full clawback at fund end: the manager’s total carry receipts are reconciled against the final portfolio return, and any overpayment is returned to investors. This is the simplest structure but creates uncertainty about the manager’s final carry quantum until late in the fund’s life.
- Escrow-based clawback: a portion of each carry distribution (typically 25% to 35%, consistent with international LP association guidance) is held in an escrow managed by an independent party. Escrow funds are released progressively as clawback risk diminishes, with full release at final liquidation after independent audit. This is the most LP-protective structure and is increasingly expected by institutional investors in Indian AIFs.
- Interim true-up: the fund tests carry entitlement at defined milestones (e.g., at 60% deployed, at 80% deployed) and adjusts future distributions rather than seeking return of past distributions. This reduces the practical challenge of enforcing a clawback against distributions already spent.
The clawback risk is asymmetric: managers of funds using deal-by-deal waterfalls who generate two or three strong early exits may distribute carry that is subsequently reversed by losses in the remaining portfolio. The PPM must specify the clawback calculation methodology, the trigger conditions, and the mechanism for returning funds (cash or escrow release).
In-specie distributions and the waterfall
A related but distinct situation arises at the end of a fund’s life when investments cannot be sold due to illiquidity. The SEBI (Alternative Investment Funds) (Amendment) Regulations, April 2024, introduced a formal dissolution period framework, permitting AIFs to distribute unsold investments in-specie (that is, as securities transferred directly to investors rather than as cash) after obtaining approval from at least 75% of investors by value of their investment in the scheme. In-specie distributions interact with the waterfall in a specific way: the fair value of the distributed securities is assessed by an independent valuer and applied as a credit against each tier of the waterfall at the time of distribution. If the fair value at distribution subsequently changes in the investor’s hands, that gain or loss belongs to the investor, not the fund. The waterfall is settled at the valuation date, not at the date the investor eventually disposes of the securities. Fund managers planning a dissolution period must ensure the PPM explicitly addresses in-specie distribution mechanics, including the valuation basis and the interaction with any outstanding carry balance or clawback obligation.
Worked numerical example of a Category II AIF waterfall
Assumptions
A Category II AIF raises ₹200 crore from investors. After management fees and expenses, the fund deploys ₹180 crore across a portfolio. The fund is structured with an 8% compound hurdle rate and 20% carry with a 100% catch-up. The fund uses a whole-fund (European) waterfall. The fund realises ₹320 crore in total exit proceeds over its tenure.
Step 1: Return of capital
Total contributed capital deployed: ₹180 crore. Investors receive ₹180 crore first. Remaining proceeds: ₹320 crore minus ₹180 crore = ₹140 crore.
Step 2: Preferred return
Assume the average holding period across the portfolio is five years. Compound 8% on ₹180 crore over five years: ₹180 crore x (1.08^5 – 1) = ₹180 crore x 0.4693 = approximately ₹84.5 crore. Investors receive ₹84.5 crore. Remaining proceeds: ₹140 crore minus ₹84.5 crore = ₹55.5 crore.
Step 3: Catch-up
Total profits above capital return: ₹320 crore minus ₹180 crore = ₹140 crore. The manager’s carry target is 20% of ₹140 crore = ₹28 crore. The manager has received nothing so far. During the catch-up, the manager receives 100% of distributions until it has received ₹28 crore. Available: ₹55.5 crore. Manager takes ₹28 crore. Remaining: ₹55.5 crore minus ₹28 crore = ₹27.5 crore.
Step 4: Residual split (80:20)
Remaining ₹27.5 crore splits: investors receive ₹22 crore (80%), manager receives ₹5.5 crore (20%).
Final distribution summary
- Investors: ₹180 crore (capital) + ₹84.5 crore (hurdle) + ₹22 crore (residual) = ₹286.5 crore
- Investment manager (carry): ₹28 crore (catch-up) + ₹5.5 crore (residual) = ₹33.5 crore
- Total check: ₹286.5 crore + ₹33.5 crore = ₹320 crore
The manager’s total carry of ₹33.5 crore is 23.9% of total profits of ₹140 crore, slightly above the 20% target because the catch-up tier means the manager receives 20% of the preferred return tranche as well. This is the intended mechanic of a full catch-up structure.
Common mistakes that expose fund managers to SEBI queries and LP disputes
Mistake 1: Copying a predecessor fund’s PPM waterfall language without updating the economics
SEBI queries routinely flag stale waterfall language: a hurdle rate from a 2019 fund that does not reflect current market rates, a catch-up provision described differently in the PPM and the LPA, or a carry percentage that changed in negotiation but was not updated in the Part A template. The PPM and LPA must align on every parameter: hurdle rate, carry percentage, catch-up structure, clawback trigger, and calculation basis.
Mistake 2: Not including a worked numerical waterfall illustration in the PPM
The SEBI Master Circular template for PPM Part A requires a numerical illustration of the distribution waterfall. Funds that describe the sequence in words without a numbers-based example receive SEBI queries during PPM review. The illustration must be consistent with the actual fund economics.
Mistake 3: Adopting a priority distribution model structure after 18/11/2024
Any new AIF scheme whose PPM is filed after 18/11/2024 that contains senior/junior unit class mechanics that result in one class bearing disproportionate losses is non-compliant with Regulation 20(21). The only exception is Large Value Funds for Accredited Investors with appropriate disclosures and investor waivers. Managers who want tranche-based risk allocation must use separate schemes within the same AIF registration rather than differential unit classes within a single scheme.
Mistake 4: Using simple interest accrual when the PPM says “compound” (or vice versa)
The difference between simple and compound hurdle accrual on a mid-sized fund runs to crores of rupees. Fund administrators have misstated preferred return calculations because the PPM used “8% per annum” without specifying the accrual basis. LPs catch this at annual audit, not during subscription. The result is a disputed distribution that damages LP trust and can require PPM amendment.
Mistake 5: No clawback mechanism in a deal-by-deal waterfall
SEBI expects a clawback provision when a deal-by-deal waterfall is used. Funds that omit it either receive SEBI queries during PPM review or face LP disputes at fund end when final realised returns fall short of modelled returns. Escrow-based clawback is the most robust structure and is increasingly a commercial expectation from institutional LPs.
Mistake 6: No in-specie distribution clause when the fund holds illiquid positions
Category II funds investing in unlisted companies or real assets often find that one or two portfolio companies remain unsold when the fund tenure expires. The SEBI April 2024 amendment provides a dissolution period pathway, but the PPM must already permit in-specie distribution; it cannot be added retrospectively without investor consent. Funds whose PPMs are silent on in-specie mechanics are forced to seek an urgent amendment at exactly the moment when LP relationships are most strained.
Treelife practitioner note
In the AIF mandates we have handled at Treelife, across fund registration, PPM drafting, LP agreement structuring, and post-launch compliance, the waterfall section is the document that reveals whether a fund’s economics are actually aligned between the manager and investors, or whether there is a disconnect that will surface as a dispute at the first major exit.
One pattern we see consistently in Category II funds launched by first-time managers: the hurdle rate is described as “8% per annum” in the PPM, the LPA says “8% simple interest”, and the fund’s financial model was built on compound accrual. That gap, modest on paper, translates to a ₹8 crore to ₹15 crore difference in preferred return on a ₹150 crore fund over a six-year hold. The LP’s fund counsel catches this at the first distribution event. By then, the PPM amendment process takes three months minimum and requires investor consent.
The other consistent issue is the November 2024 Regulation 20(21) transition for existing funds. Fund managers who ran a tiered unit class structure believing it fell outside SEBI’s 2022 circular are now re-examining whether they need to report those differential rights to SEBI and whether their ability to accept new commitments is affected. The December 2024 implementation circular contains specific exemptions: the manager/sponsor carry carve-out, the excused investor carve-out, and the LVF carve-out. Most well-structured funds will find at least one that applies. But the legal memo confirming which exemption applies needs to be on file before the fund accepts its next drawdown.
The carry taxation issue is cleaner now than it was 18 months ago. Budget 2025’s capital gains clarification for Category I and II AIF securities means the characterisation question for equity-oriented funds is largely settled from AY 2026-27. For private credit funds distributing interest, the pass-through mechanics mean carry still flows at the investor’s slab rate for the interest component. Planning for this at fund launch, not at the first distribution event, is what separates well-structured mandates from ones that create tax surprises for the manager.
Frequently asked questions on AIF Waterfall
Q: What is the standard hurdle rate for a Category II AIF in India?
A: The most common hurdle rate is 8% per annum, though structured credit and private debt funds sometimes set it at 10% to 12%. The hurdle rate is a commercial term negotiated between the manager and investors and must be disclosed in the PPM under the SEBI Master Circular template.
Q: Is carried interest taxed as capital gains or income in India?
A: For Category I and II AIFs, Budget 2025 (Finance Act 2025) clarified that securities held by these funds are capital assets under Section 2(14), and income from their transfer is capital gains. Carry distributions flowing from equity gains are therefore capital gains in the manager’s hands from AY 2026-27. For interest-dominant Category II funds, carry attributable to interest income may retain its character as interest, taxed at slab rates.
Q: Can an Indian AIF use an American deal-by-deal waterfall?
A: Yes. Deal-by-deal waterfalls are permitted and appear in the market, particularly in VC and growth equity funds. The PPM must disclose the deal-by-deal structure and include a clawback mechanism to protect investors from overpayment of carry in early successful exits.
Q: What is the priority distribution model and why did SEBI restrict it?
A: The priority distribution model refers to AIF structures where senior unit holders receive preferential returns (effectively guaranteed distributions) while junior unit holders bear disproportionate losses. SEBI found this structure violated investor fairness principles, initially restricting it via a circular in November 2022 and then codifying the prohibition through Regulation 20(21) inserted by the Fifth Amendment Regulations on 18/11/2024.
Q: Is carried interest clawback legally enforceable in India?
A: Yes, clawback provisions are contractual obligations under the contribution agreement and LPA. They are enforceable under Indian contract law. Enforcement against distributed cash is practically challenging; escrow-based structures where carry is held pending final portfolio realisation are the operationally safer mechanism.
Q: What are the TDS obligations on AIF distributions?
A: For Category I and II AIFs, TDS on income paid or credited to resident investors is governed by Section 194LBB (Section 393(1) under the Income Tax Act 2025, effective 01/04/2026) at 10%. For non-residents, TDS applies at rates under Section 195, subject to DTAA relief where valid documentation is submitted. TDS at 10% is not the final tax; investors pay advance tax at their applicable effective rate.
Q: Can an LVF (Large Value Fund for Accredited Investors) have a non-standard waterfall?
A: Yes. LVFs are exempt from the pari-passu requirement in Regulation 20(22). They may issue differential rights to investors, including non-standard distribution waterfalls, provided the PPM discloses the differential rights and each investor provides a written waiver at on-boarding acknowledging the departure from pari-passu.
Q: Do the Regulation 20(21) pro-rata requirements apply to carry distributions to the investment manager?
A: No. The December 2024 SEBI circular explicitly exempts distributions to the investment manager or sponsor under a contribution agreement from the pro-rata requirement. This means carried interest distributions that are disproportionate to the manager’s unit holding remain permissible.
Q: How does a catch-up provision differ from a carried interest distribution?
A: The catch-up and carried interest are both manager-facing distribution tiers, but they operate sequentially. The catch-up allows the manager to receive a larger share of proceeds immediately after the hurdle is cleared, to bring the manager’s cumulative share of all profits to date up to the agreed carry percentage (e.g., 20%). The carried interest then applies to the remaining profits after the catch-up. Together, they ensure the manager’s total take is 20% of all profits above contributed capital, not just 20% of profits above the preferred return.
Q: What happens to the waterfall if an investor defaults on a capital call?
A: Under Regulation 20(21), a defaulting investor may be excluded from participation in the relevant investment without triggering the pro-rata requirement for other investors. The fund’s contribution agreement typically contains default provisions (interest on overdue amounts, dilution of the defaulting investor’s interest, forced transfer at a discount) which interact with the waterfall mechanics. The specific consequences must be disclosed in the PPM.
Q: How does a GIFT City AIF waterfall differ from a domestic SEBI-regulated AIF?
A: GIFT City AIFs registered with the International Financial Services Centres Authority (IFSCA) under the IFSCA (Fund Management) Regulations 2022 operate under a separate regulatory framework. Waterfall mechanics follow similar PE conventions, but IFSCA’s disclosure requirements and the SEBI AIF pro-rata framework do not directly apply. Tax treatment differs: Category III equivalent GIFT City funds benefit from a 10-year business income tax holiday. Non-resident investors in qualifying GIFT City funds may be exempt from Indian income tax return filing.
Q: What documents govern the distribution waterfall in an Indian AIF?
A: Three documents govern the waterfall: (1) the PPM (Part A), which contains the regulatory disclosure and must include a worked numerical example; (2) the LPA or contribution agreement, which contains the contractual mechanics including clawback and default provisions; and (3) any side letters with specific LPs that modify standard terms. Side letters must not contradict the PPM disclosure or adversely affect other investors’ economic rights.
Regulatory references:
- SEBI (Alternative Investment Funds) Regulations 2012, Regulation 20(21) and Regulation 20(22), as inserted by the Fifth Amendment Regulations notified on 18/11/2024
- SEBI Master Circular for Alternative Investment Funds dated 03/06/2026 (supersedes Circular No. SEBI/HO/AFD-1/MIRCIR/P/CIR/2024/58 dated 07/05/2024)
- SEBI Circular on Pro-rata and pari-passu rights of investors of AIFs, dated 13/12/2024
- SEBI Draft Circular for Public Comments: Clarifications and specific modalities with respect to maintaining pro-rata rights of investors of AIFs, dated 07/11/2025
- SEBI Circular on Priority Distribution Model, dated 23/11/2022
- SEBI (Alternative Investment Funds) (Amendment) Regulations, April 2024 (dissolution period framework and in-specie distribution)
- SEBI Circular SEBI/HO/AFD/PoD/CIR/2024/5 dated 12/01/2024 (dematerialisation of AIF investments, mandatory for all new investments from 01/07/2025)
- Income Tax Act 1961, Section 115UB (pass-through regime for Category I and II AIFs)
- Income Tax Act 1961, Section 194LBB (TDS on AIF distributions to resident investors)
- Income Tax Act 1961, Section 2(14) as amended by Finance Act 2025 (capital asset definition for AIF securities, effective AY 2026-27)
- Finance (No. 2) Act 2024, amendments to Section 112A and Section 111A (capital gains rates effective 23/07/2024)
- Income Tax Act 2025, Section 393(1) (renumbered equivalent of Section 194LBB, effective 01/04/2026)
- IFSCA (Fund Management) Regulations 2022, as amended
