Summary of this article
Understanding the purpose of a lock-in is just as important as understanding the returns an AIF seeks to deliver.
One of the lesser-known reassuring facts in the AIF framework is that the fund manager or sponsor is also required to invest their own money in the fund.
Lock-in isn't the price you pay to access illiquid, high-return strategies. It's the mechanism that makes those strategies deliverable in the first place.
When most investors first look at an Alternative Investment Fund (AIF), the first question they ask themselves isn’t “How much money can I make?” It’s “When can I get my money back?”
Too often investors view the lock-in period as a negative - something to get past before they can even consider the potential benefits of the AIF.
That’s short sighted.
The lock- in period isn’t some random constraint the fund throws on investors. It’s a fundamental aspect of how AIFs work. It allows managers the time to find the right deals, work to create value in the underlying business or asset, and exit at the right time - not just when they have to sell to pay an impatient redeeming investor.
Understanding the purpose of a lock-in is just as important as understanding the returns an AIF seeks to deliver.
So, a query like "How soon can I withdraw my money” may sound normal, but liquidity isn’t always a good idea. Patience delivers the results, especially in the case of equity investments. Hence, it is one of the most structural reasons investment strategies work out in the first place.
Category I and II AIFs are mandated by SEBI to be close-ended, with a minimum tenure of three years, calculated from the date the fund makes its final closing. Category III can be open or close-ended.
Let’s Get Through The Investment Tenure Of The Lock-ins:
Investment period: Typically the first 2-3 years, where capital is actually deployed into portfolio companies or assets.
Holding / harvest period: Where investments mature and are actively managed toward an exit
Exit window: Where positions are sold, IPO'd (when the company goes public through an initial public offering), or otherwise monetised and proceeds distributed.
Tenure is the total runway the fund manager needs to take capital through all three phases without being forced to compress any of them.
Hard Lock-In, Soft Lock-In, And Where Exit Load Fits
Hard lock-in is a complete restriction on withdrawal. Redemption is not allowed under any circumstance, at any cost, during the period. “This is the form of lock-in which SEBI prescribes for Category I and II AIFs which have a close-end structure where there is no provision for redemption during the period except for a secondary transfer with the permission of the manager,” says CA Kresha Gupta, Director and Fund Manager, Steptrade Capital, a leading investment management company and SEBI-registered AIF manager.
Unlike hard lock-in, a soft lock-in allows redemption but the investor has to pay a fee known as an exit load for withdrawing from the scheme within the specified period.
An exit load can be imposed only if the scheme has provisions for redemption in the first place. In a hard lock-in, redemption cannot be made within a specified period, so no exit load can be charged. In soft lock-in schemes, the scheme has to allow periodic redemptions within a minimum holding period and if you choose to redeem before that period, you are subject to an exit load which is usually around 1–3 per cent.
Lock-In Isn't Uniform Across AIF Categories Either:
Category I and II: Hard lock-in by regulation. Structured as closed-end, with a minimum of 3-year holding period, and no redemption option available during the period. The only way out before maturity is through manager-approved secondary transfer.
Category III, closed-ended: The same hard lock-in mechanics as Category I and II, with tenure typically running 3 to 7 years depending on strategy.
Category III, open-ended: This is where soft lock-in shows up. These funds often run periodic subscription and redemption windows, with a soft lock-in of roughly one to three years and an exit load for redemptions made before that period is up.
What Should Investors Note Here?
Before assuming that your money is “locked for X years,” find out what kind of lock-in is specified in your Private Placement Memorandum (PPM). “There can be a hard lock-in as well as a soft lock-in with a three-year exit load period that are referred to as “3-year lock-in” in a casual way. The implications of those two types of lock-in are entirely different,” says Gupta.
Why Is It Necessary?
Private assets cannot be sold overnight: Illiquid assets can't be sold on a short notice without a discount. If an AIF holding SME or pre-IPO positions had to honour redemptions on demand, it would have two options: hold a permanent cash buffer that drags on returns, or sell good positions early at a bad price to fund the exit. Lock-in removes that choice entirely.
Value creation demands time: The businesses that AIFs invest in are often still growing.
“A pre-IPO company, for example, may need several years to expand its operations, improve profitability, strengthen governance, and prepare for a successful listing. Similarly, a private equity investment may require time for operational improvements before it reaches its full potential,” says Gupta, adding, “if capital could be withdrawn midway through this journey, the fund might be forced to exit before the investment has had the opportunity to create its intended value.”
Simply put, private market investing is a long-term process, and the investment horizon should match the time needed for that value to be realised.
The Alignment problem: One of the lesser-known reassuring facts in the AIF framework is that the fund manager or sponsor is also required to invest their own money in the fund.
Under SEBI regulations, the sponsor or fund manager must maintain a continuing investment in the AIF, typically 2.5 per cent of the corpus or Rs 5 crore, whichever is lower (subject to the applicable category and regulations).
More importantly, their investment remains locked in alongside the investors' capital. “Their returns depend on the same investment outcomes, and they cannot simply exit early if markets become volatile. This creates an important alignment of interests: the fund manager succeeds only when the investors succeed. It reinforces the idea that the manager is investing alongside investors, not merely managing their capital,” informs Gupta.
Liquidity Risk Is Not Investment Risk - And Conflating Them Is The Costliest Mistake
When evaluating an AIF, many investors focus on a single idea of risk. But there are two separate questions you should ask:
Can I lose money? (investment risk)
Can I access my money whenever I want? (liquidity risk)
Investment risk is the chance that your investment underperforms. The portfolio company doesn't grow as expected, market conditions shift or the fund sells its investments at lower than projected valuations. This is the risk every investor knowingly takes. The risk is reduced by smart investment selection, thorough due diligence, diversification as well as the fund manager's skill.
“Liquidity risk, on the other hand, is about when you can access your money. Even if the fund is meeting its objectives and the underlying investments are doing well, your capital may remain locked in until the fund reaches the appropriate stage to exit those investments. That isn't a sign that the fund is underperforming; it's simply how long-term private market investing is designed to work,” says Gupta.
This distinction matters because many investors assume that if their money is locked in, the investment must also be riskier. But that isn't necessarily true.
Category II AIFs may have a thoroughly researched investment strategy, robust governance and high-quality assets so the investment risk can be very low. Yet, they can still have high liquidity risk simply because your capital is committed for the life of the fund.
“On the other hand, a listed stock is highly liquid - you can usually sell it on any trading day. But that doesn't make it a safer investment. If the company performs poorly, the value of your investment can still decline significantly,” says Gupta.
In simple terms, the ability to exit quickly does not determine how risky an investment is. Likewise, a lock-in period does not automatically make an investment unsafe.
What To Actually Ask Before You Commit?
Since lock-in is permanent for the duration you agree to, the diligence should happen before signing, not after.
On liquidity risk:
Can I genuinely go without this capital for the full stated tenure?
Does the PPM permit secondary transfer, and on what terms?
Are the fund units eligible for exchange listing, and has the fund manager indicated intent to list?
On investment risk:
What does the distribution policy say - proceeds returned as realised, or reinvested?
Has the manager's continuing interest actually been contributed, and is it disclosed?
What's the fund's stated plan for the exit window - timeline, not just intent?
None of these changes the fact that your capital is locked in. What they change is whether you understand ‘what you've agreed to’.
Lock-in isn't the price you pay to access illiquid, high-return strategies. It's the mechanism that makes those strategies deliverable in the first place. An AIF without lock-in wouldn't be a better version of the same product; it would be a fundamentally different, weaker one, forced to hold cash it can't deploy or sell assets it shouldn't be selling.
