Differential Distribution

Regime: SEBI AIF and IFSC. Also known as: priority distribution; senior and junior (or subordinate) units; first-loss structure.

1. Executive summary

In brief. Differential distribution is an arrangement in which investors in the same fund do not share its gains and losses in proportion to the money each committed. One class, usually called senior, is paid first or shielded from early losses. Another, called junior or subordinate, is paid later, earns less, or absorbs losses first. It is used to draw cautious capital into riskier strategies, and in blended finance, where development or philanthropic money cushions commercial investors. India's two fund regimes treat it very differently. In a SEBI-registered alternative investment fund, investors must share pro rata, and only a short list of investors, such as the sponsor, development institutions and government bodies, may take the junior position. In a GIFT City fund, any investor putting in at least USD 2 million may take it, subject to disclosure and independent valuation.

Key points

• SEBI AIFs. The default is a pro-rata right in each investment and each distribution. A junior class is open only to the manager or sponsor, development financial institutions, State industrial development corporations and government-owned or controlled entities.

• IFSC funds. Venture Capital Schemes and Restricted Schemes may issue one senior class and one or more junior classes under IFSCA's framework of 25 September 2026. The junior minimum is USD 2 million, or USD 1 million for certain accredited investors.

• The interpretive divide. SEBI treats a junior class as an exception to equal treatment, allowed by who the investor is. IFSCA treats it as a disclosed bargain, allowed by how much the investor commits.

• Practical consequence. A waterfall that is lawful in an IFSC scheme may be unavailable in a domestic AIF. Neither regime's answer can be read into the other.

• Common ground. Both regulators restrict the fund's money being used to repay debts owed to those on the junior side.

2. The rule

SEBI AIF regime

The rule sits in the regulations, and the exceptions sit in a circular issued under them.

1. Pro-rata rights. Regulation 20(21) of the SEBI (Alternative Investment Funds) Regulations, 2012 ("AIF Regulations") gives the investors of a scheme "rights, pro-rata to their commitment to the scheme, in each investment of the scheme and in the distribution of proceeds". [1] A proviso deals with schemes that gave non-pro-rata rights before the amendment was notified.

2. Pari-passu rights. Regulation 20(22) makes investors' rights pari passu in all aspects. Its provisos allow differential rights for select investors "without affecting the interest of other investors", and exempt a large value fund for accredited investors ("LVF"). [2]

3. Exceptions. SEBI's circular dated 13 December 2024 ("SEBI Circular") disapplies the pro-rata rule where an investor is excused or excluded from an investment, or has defaulted on a drawdown. It also disapplies it for carried interest shared with the manager or sponsor. [3]

4. The junior class. Paragraph 5 of the SEBI Circular lists who may subscribe to junior or subordinate units and accept lower returns or greater losses: the manager or sponsor; multilateral or bilateral development financial institutions; State industrial development corporations; and entities established, owned or controlled by the Central Government, a State Government or a foreign government, including central banks and sovereign wealth funds. [3]

5. Condition. Where the manager or sponsor holds the junior class, the money the AIF invests must not be used by the investee to repay obligations owed to the manager, the sponsor or their associates. [3]

6. Power. The SEBI Circular is issued under section 11(1) of the SEBI Act, 1992, read with regulations 20(21), 20(22) and 36 of the AIF Regulations. [7]

IFSC regime

Here the regulations permit the structure and a circular supplies the conditions.

Enabling provisions. Regulation 23(5) of the IFSCA (Fund Management) Regulations, 2025 ("FM Regulations") applies to Venture Capital Schemes, and regulation 35(6) to Restricted Schemes. Each requires the Fund Management Entity ("FME") to ensure that differential distribution rights given through senior and junior or subordinate units are "in accordance with the framework as may be specified by the Authority". [10]

Definitions. The Explanation to each provision describes senior units as the class with "superior rights over the distribution proceeds". Junior or subordinate units, including mezzanine units, are classes whose rights over distribution proceeds are inferior to senior units. [10]

The framework. IFSCA's circular dated 25 September 2026 ("IFSCA Framework") is issued under sections 12 and 13 of the IFSCA Act, 2019, read with those two provisions. [11] Its main rules are:

• only one class of senior units, which "shall not differ in terms of risk, priority of returns or loss absorption"; [12]

• junior holders may bear losses beyond their pro-rata share, accept lower or zero returns, or give a grant to an ESG Scheme; [13]

• a minimum subscription to junior units of USD 2 million, or USD 1 million for an Accredited Investor as the clause defines it; [16]

• prescribed disclosures in the placement memorandum ("PPM"), including tabular waterfall examples; [14]

• NAV for each class computed by an independent valuer; [17]

• for ESG Schemes, grants of up to 49% of corpus. [15]

3. How it got here

SEBI first froze the structure and then confined it; IFSCA later enabled it by regulation.

SEBI's purpose. SEBI's Board memorandum reasons from the nature of a pooled fund. It calls pro-rata sharing "an essential characteristic of the AIF as a pooling vehicle". [8]

The memorandum also records a specific abuse. Regulated lenders subscribed to junior classes of schemes that invested in debt of the lenders' own stressed borrowers. That moved stressed assets off the lenders' books and deferred recognition of deteriorating credit. [8]

The memorandum acknowledges blended finance as a legitimate use. That explains why development institutions and government bodies appear on the permitted list. [8]

How existing SEBI schemes were treated. Schemes with a priority distribution model that fall outside the permitted list may keep existing investments. They may not accept fresh commitments or invest in a new investee company. [4]

IFSCA's purpose. The IFSCA Framework recites two aims: blended finance, following a recommendation of IFSCA's Expert Committee on Sustainable Finance, and industry requests for multiple unit classes in schemes for sophisticated investors. [11]

In our view, IFSCA addresses the abuse SEBI identified through a condition on the use of debt proceeds, in clause 8(a), and not through a limit on who may invest. [17]

4. Reading the rule

Is a junior class an exception to equal treatment, or a bargain that disclosure makes fair?

It is an exception under SEBI's rules and a bargain under IFSCA's. This is settled on the text of each regime.

(i) The words. SEBI: rights "pro-rata to their commitment ... in the distribution of proceeds". [1] IFSCA: differential distribution rights "in accordance with the framework". [10]

(ii) The readings. On one reading, pro-rata sharing is inherent in pooling, so any departure needs the regulator's permission. On the other, distribution is a matter of agreement among investors, so a disclosed waterfall is enough.

(iii) Support. SEBI adopts the first reading at the level of regulation, and its Board memorandum grounds it in equal and fair treatment of fund investors. [8] IFSCA's regulations presuppose that differential rights may be given and regulate only how. [10]

(iv) Weight. Both positions rest on regulations, with circulars supplying detail. Neither depends on FAQs or informal guidance.

(v) View. In our view the two regimes rest on different premises, and a structure's validity in one gives no comfort in the other.

In a SEBI AIF, can an investor outside the list agree to take first loss?

In our view, no. This is arguable at the margin.

(i) The words. Paragraph 5 of the SEBI Circular names the entities that may subscribe to junior classes. [3]

(ii) The readings. The list may be exhaustive. Or a first-loss commitment might be offered as a "differential right" under the first proviso to regulation 20(22), since it favours the other investors. [2]

(iii) Support. Three points favour the exhaustive reading. Differential rights "shall not result in any investor bearing liability accrued or accruing to other investors", which is what a first-loss class does. [5] Differential rights must come from a positive list set by the Standard Setting Forum for AIFs. [5] And existing priority distribution schemes outside the list were frozen, which would be pointless if the list were open. [4]

(iv) Weight. All three points come from the SEBI Circular, read with the regulation it implements.

(v) View. In our view the list is closed. The residual risk runs the other way: a structure that achieves first-loss economics by another route may be treated as a breach of regulation 20(21).

Does SEBI's large value fund exemption open the door?

In our view it does not, but this is unsettled.

The SEBI Circular exempts an LVF from maintaining pari-passu rights, on disclosure in the PPM and a waiver from each investor. [6] The exemption is tied to regulation 20(22). The paragraphs of the SEBI Circular on pro-rata rights state no matching exemption for an LVF. [3]

A first-loss class alters the distribution of proceeds, which regulation 20(21) governs. In our view an LVF therefore remains confined to the paragraph 5 list for a junior class. The point depends on the full text of regulation 20(21), which should be read before relying on this view.

In an IFSC scheme, does the USD 1 million threshold cover accredited individuals?

No, on the text. The Explanation to clause 7 defines Accredited Investor by reference only to clauses 1(c) to 1(f) of IFSCA's circular on Accredited Investors in IFSC. [16] Those clauses cover partnership firms, trusts, bodies corporate and deemed accredited investors. Individuals fall under clause 1(a) and family structures such as Hindu undivided families under clause 1(b).

In our view an accredited individual needs USD 2 million to hold junior units. The defined term is local to clause 7 and does not change who is an accredited investor elsewhere in the FM Regulations.

How far does IFSCA's restriction on the use of debt proceeds reach?

Further than SEBI's on whom it protects against, and less far on what it covers. Its outer edge is arguable.

(i) The words. Money invested "by way of debt instruments shall not be utilised, directly or indirectly" to discharge the investee's debt owed to regulated investors, the FME, or their associates. The condition does not apply where the contribution of each investor, with its associates, does not exceed 20% of corpus. [17]

(ii) The readings. "Each investor" may mean every investor in the scheme, or only each regulated investor. The first reading keeps the condition alive whenever any one investor exceeds 20%.

(iii) Support. The proviso says "each investor" without qualification, which favours the wider reading. The mischief, a lender refinancing its own borrower through the fund, favours the narrower one.

(iv) Comparison. SEBI's condition applies only where the manager or sponsor holds the junior class, but covers every investment, not only debt. [3]

(v) View. In our view the wider reading is safer. The obligation is one of diligence by the FME and its key managerial personnel, so a documented check is the practical answer on either reading.

5. SEBI and IFSCA compared

In our view the regimes differ because the regulators started from different problems. SEBI was responding to misuse of junior tranches by lenders in a domestic market it shares with the banking regulator. IFSCA was designing for cross-border blended finance and for investors it regards as sophisticated.

SEBI's Board memorandum itself draws on Article 23 of the EU Alternative Investment Fund Managers Directive and IOSCO material on fair treatment of fund investors. [8] That is context for SEBI's rule and not authority on what it means.

6. In the documents

Placement memorandum. In an IFSC scheme the PPM must set out each class and its distribution rights on an ongoing basis, at redemption and on winding up. It must add tabular examples of the waterfall, including scenarios where junior capital is lost, and the risks for each class. [14] In a SEBI AIF the PPM must disclose any differential right and who is eligible for it. [5]

Contribution or subscription agreement. This is where the waterfall binds. If junior units can convert into a superior class, the milestones, triggers, methodology and formulae must also be expressly disclosed in the PPM. [12] For a SEBI AIF, carried interest is outside the pro-rata rule only as shared under the contribution agreement. [3]

Trust deed or LLP agreement. Check that the constitutive document permits classes of units with different distribution rights before the PPM promises them. This is a drafting point and not a statement of what trust or partnership law requires.

Side letters. In an IFSC scheme, senior units may differ on fees, currency and operational aspects, and on nothing that changes risk, priority of returns or loss absorption. [12] In a SEBI AIF, differential rights may be given only in line with the implementation standards of the Standard Setting Forum for AIFs. [5]

Valuation policy. An IFSC scheme needs a documented process for an independent valuer to compute NAV for each class. [17]

Grant documents. An ESG Scheme accepting grants needs a written policy on acceptance, administration and deployment, disclosed in the PPM. [15]

Illustration. A scheme raises USD 100 million: USD 80 million senior and USD 20 million junior, with the junior class absorbing losses first. The portfolio returns USD 85 million, ignoring fees and expenses. Pro rata, senior would receive USD 68 million and junior USD 17 million. Under the first-loss waterfall, senior receives USD 80 million and junior USD 5 million.

Practice Note: [Reviewing lawyer to add. Suggested points: how first-loss classes are being sized and priced in IFSC blended finance funds; how carried interest is layered over senior and junior classes; what investors ask for in conversion triggers.]

7. Open questions

• Transition in the IFSC. The IFSCA Framework has no transition clause. Its effect on schemes launched before 25 September 2026 with class-based waterfalls is not stated.

• The 20% proviso. Whether "each investor" means every investor or only each regulated investor is arguable. See section 4.

• "Operational aspects". The IFSCA Framework does not define which senior-class differences are operational.

• LVFs under SEBI rules. Whether an LVF may offer a junior class to investors outside the paragraph 5 list is unsettled. See section 4.

• Carried interest in the IFSC. How carried interest units interact with the one-senior-class rule is not addressed in the provisions read.

• Tax. Neither the SEBI Circular nor the IFSCA Framework addresses the tax treatment of differential returns or grants.

8. FAQs

What is differential distribution in a fund?

Differential distribution is an arrangement in which classes of investors in the same fund share its gains and losses unequally, and not in proportion to their commitments. A senior class is paid first or protected from early losses. A junior or subordinate class is paid later, earns less, or absorbs losses first. SEBI's rules call the structure a priority distribution model.

What is the difference between senior and junior units?

Senior units rank ahead of junior units in distributions. The IFSCA (Fund Management) Regulations, 2025 describe senior units as the class with superior rights over a scheme's distribution proceeds. Junior or subordinate units, including mezzanine units, have inferior rights. Under IFSCA's framework, junior holders may bear losses beyond their pro-rata share or accept lower or zero returns.

Is differential distribution allowed in a SEBI AIF?

Only in limited cases. Regulation 20(21) of the SEBI (Alternative Investment Funds) Regulations, 2012 gives investors rights pro rata to their commitment in each investment and in distributions. SEBI's circular dated 13 December 2024 permits a junior class only for specified investors, and treats carried interest and excused, excluded or defaulting investors as separate exceptions.

Who can invest in the junior class of a SEBI AIF?

Four categories can: the manager or sponsor of the AIF; multilateral or bilateral development financial institutions; State industrial development corporations; and entities established, owned or controlled by the Central Government, a State Government or a foreign government, including central banks and sovereign wealth funds. The list is in paragraph 5 of SEBI's circular dated 13 December 2024.

Can a GIFT City fund issue senior and junior units?

Yes, if it is a Venture Capital Scheme or a Restricted Scheme. Regulations 23(5) and 35(6) of the IFSCA (Fund Management) Regulations, 2025 permit differential distribution through senior and junior or subordinate units, in line with IFSCA's framework dated 25 September 2026. The scheme may have only one class of senior units.

What is the minimum investment for junior units in an IFSC scheme?

The minimum investment for junior or subordinate units in an IFSC scheme is USD 2 million. It is USD 1 million for an Accredited Investor, defined for this purpose as a partnership firm, trust, body corporate or deemed accredited investor under IFSCA's circular dated 25 January 2024. Accredited individuals are outside that definition. No minimum applies to grants.

Can a SEBI large value fund offer a first-loss class?

This is unsettled; the better view is that it cannot do so for investors outside SEBI's permitted list. SEBI's circular dated 13 December 2024 exempts a large value fund for accredited investors from pari-passu rights, with disclosure and investor waivers. It states no matching exemption from the pro-rata rule, which governs how proceeds are distributed.

What is the difference between pro-rata and pari-passu rights in an AIF?

Pro-rata rights concern proportion; pari-passu rights concern ranking. Under regulation 20(21) of the SEBI (Alternative Investment Funds) Regulations, 2012, investors share in each investment and each distribution in proportion to their commitments. Under regulation 20(22), investors' rights rank equally in all aspects, except for differential rights that do not affect the interest of other investors.

What must an IFSC fund disclose about its waterfall?

An IFSC fund with senior and junior units must disclose the waterfall in its placement memorandum. IFSCA's framework requires details of each class and its distribution rights on an ongoing basis, at redemption and on winding up, tabular examples covering scenarios where junior capital is lost, and the risks particular to each class.

9. Related entries

• Existing: Side letters that don't come back to bite.

• Coming Soon: Pro-rata and pari-passu rights; Distribution waterfall; Carried interest; Accredited investor; Large value fund for accredited investors; Venture Capital Scheme; Restricted Scheme; ESG scheme and grants.

10. Authorities

1. SEBI (Alternative Investment Funds) Regulations, 2012, regulation 20(21), as set out in the SEBI Circular (note 3), paragraphs 1 and 2.

2. AIF Regulations, regulation 20(22) and its provisos, as set out in the SEBI Circular, paragraph 11.

3. SEBI, Pro-rata and pari-passu rights of investors of AIFs, Circular SEBI/HO/AFD/AFD-POD-1/P/CIR/2024/175 dated 13 December 2024, paragraphs 3 to 6.

4. SEBI Circular, paragraphs 7 to 10.

5. SEBI Circular, paragraphs 12 to 15.

6. SEBI Circular, paragraphs 11, 18 and 19.

7. SEBI Circular, paragraph 23.

8. SEBI, Memorandum to the Board: Pro-rata and pari-passu rights of investors of Alternative Investment Funds.

9. SEBI, Master Circular for Alternative Investment Funds (AIFs), HO/19/34/11(6)2025-AFD-POD1/I/12928/2026 dated 3 June 2026, Chapter 19.

10. International Financial Services Centres Authority (Fund Management) Regulations, 2025, regulations 23(5) and 35(6) with their Explanations, as inserted by the International Financial Services Centres Authority (Fund Management) (Second Amendment) Regulations, 2026. Gazette copy to be linked.

11. IFSCA, Framework for differential distribution in Venture Capital Schemes and Restricted Schemes to facilitate blended finance and other fund structures, Circular F. No. IFSCA-DSF0SFHB/1/2025-Capital Markets dated 25 September 2026, covering paragraphs 1 to 5 and Annexure clause 1.

12. IFSCA Framework, Annexure clauses 2 and 3.

13. IFSCA Framework, Annexure clause 4.

14. IFSCA Framework, Annexure clause 5.

15. IFSCA Framework, Annexure clause 6.

16. IFSCA Framework, Annexure clause 7 and Explanation; IFSCA, Accredited Investors in IFSC, Circular F. No. IFSCA-IF-10PR/1/2023-Capital Markets dated 25 January 2024, clause 1.

17. IFSCA Framework, Annexure clause 8.