Since 25 September 2026, funds in GIFT IFSC may divide their investors into senior and junior classes, with some agreeing to lose first or earn less so that others will invest at all. Onshore, SEBI continues to insist that investors in an AIF share economics pro rata and pari passu. Two Indian regulators now hold two different ideas of what it means for a fund to be fair.
Imagine two investors in the same fund. One is a pension fund that will commit only if its capital is reasonably protected. The other is a development finance institution or a philanthropic foundation, whose real objective is to see clean energy built or small businesses financed, and which is prepared to absorb the first losses to make that happen. Under the traditional model of an Indian fund, both must be treated alike. Every investor shares profits and losses in proportion to what it has committed, and neither can be given a better or worse economic deal.
The International Financial Services Centres Authority ("IFSCA") has now moved away from that model for funds based in GIFT IFSC. By a circular dated 25 September 2026, issued under the IFSCA (Fund Management) Regulations, 2025 and effective immediately, Venture Capital Schemes and Restricted Schemes may issue a senior class of units alongside junior or subordinate classes with differential distribution rights. The change is technical in form, but in substance it represents a different philosophy of investor protection. This article examines it through three questions, i.e., how the structure works for the investors on either side of it, how it compares with SEBI's regime for domestic AIFs, and whether it can bring commercial capital into impact and ESG investing.
What The Framework Permits
A scheme using the framework may have only one class of senior units. All senior units must rank equally in risk, priority of returns and absorption of losses, although they may differ in matters such as fees, currency and operational terms. Every other class must be junior or subordinate. Investors in a junior class may agree to bear losses beyond their pro-rata share, to accept lower or no financial returns, or, in the case of an ESG Scheme, to provide a grant.
The framework comes with safeguards. An investor in junior units must commit at least USD 2 million, or USD 1 million if it is an accredited investor, although no minimum applies to grants. The placement memorandum must set out the distribution rights of each class across ongoing distributions, redemption and winding up, illustrate the waterfall in tabular form including scenarios in which junior investors lose capital, and disclose the class in which the fund manager or its associates have invested. Junior units may convert into a higher class only if the milestones and conditions for conversion are disclosed upfront, and the net asset value of each class must be computed by an independent valuer. For ESG Schemes, grants are capped at 49 per cent of the corpus, must be accounted for separately, must comply with the Foreign Contribution (Regulation) Act, 2010 where it applies, and must be returned if unutilised on winding up. The cap is notably higher than the 20 per cent proposed when IFSCA consulted on the framework in October 2025.
Question One: Who Gains From A First-Loss Tranche, And At What Cost?
The economics are easiest to understand through a simple illustration. Suppose a fund raises USD 100 million, of which USD 80 million comes from senior investors and USD 20 million from a junior investor that has agreed to absorb losses first. If the portfolio is eventually worth USD 85 million, the USD 15 million loss falls entirely on the junior investor. The senior investors recover their full USD 80 million, while the junior investor recovers only USD 5 million. In a conventional fund, the same loss would have been shared pro rata, and every investor would have lost 15 per cent.
For the senior investor, the junior tranche acts as a cushion. Hence, a pension fund or insurer that could not accept the full risk of an early-stage or emerging market portfolio may be able to invest behind a first-loss layer. For the junior investor, the trade-off is clear. It accepts concentrated downside, and possibly a capped or zero return, in exchange for making the fund possible at all. A commercial investor would rarely accept that bargain, which is why junior capital in practice tends to come from development institutions, governments, foundations and the fund manager itself.
The real legal risk lies in the drafting. A junior investor needs to know exactly when its losses are triggered, how they are calculated at each stage of the fund's life, and whether it has any route to conversion if the fund performs well. Thus, the tabular waterfall disclosures required by IFSCA are not merely a formality, but the main protection the junior investor has.
Question Two: Is GIFT IFSC Now The More Flexible Home?
SEBI's position is markedly different. Following amendments to the SEBI (Alternative Investment Funds) Regulations, 2012 in November 2024 and a circular of 13 December 2024, investors in a domestic AIF must participate in investments and receive distributions strictly in proportion to their commitments, and must enjoy pari passu rights, subject to narrow exceptions. Subordinate units may be issued only to the manager or sponsor, multilateral and bilateral development institutions, State industrial development corporations and certain government entities, and AIFs using priority distribution models have been barred from accepting new commitments or making new investments since November 2022. Large Value Funds for accredited investors may be exempted from the pari passu requirement, but only with specific disclosure and written waivers.
The contrast is one of philosophy. SEBI treats differential economics as a risk to be contained, and fairness is achieved by treating all investors alike. IFSCA treats them as a design tool, and fairness is achieved by ensuring that every investor knows precisely what it has agreed to. Under IFSCA's framework, any investor who meets the minimum investment threshold may take junior units, and not only the categories SEBI permits.
However, flexibility should not be the only factor in choosing a jurisdiction. A fund in GIFT IFSC operates in foreign currency and, for the purposes of Indian exchange control, is treated as a person resident outside India, so its investments into India must comply with the rules on foreign investment. A fund whose investors and portfolio are largely domestic may therefore find a SEBI-registered AIF simpler despite its rigidity, whereas a fund raising capital from international development institutions and global investors may find the IFSC structure a far better fit.
Question Three: Can Differential Returns Unlock ESG And Blended Finance?
This is where the framework is most significant. Blended finance relies on public or philanthropic capital taking on risk that commercial investors will not, so that commercial capital follows. OECD analysis published in February 2026 of blended finance funds investing in Africa found that commitments to junior tranches mobilised more private capital than any other type of commitment, generating over USD 6.8 billion out of a total of USD 13.9 billion. The same analysis cautioned that concessional capital which is too large, or poorly placed, can dilute that effect and distort markets.
IFSCA's framework expressly contemplates the arrangements on which blended finance depends, i.e., junior investors accepting greater losses or lower returns, and grant capital sitting within the same scheme as commercial investment. A climate or social impact fund can now combine a grant, a first-loss tranche from a development institution and a senior tranche for commercial investors in a single regulated vehicle in India. IFSCA has itself linked the framework to the recommendations of its Expert Committee on Sustainable Finance, which favoured enabling blended finance in GIFT IFSC.
That said, the flexibility carries its own risks. ESG Schemes must disclose how they align with the Sustainable Development Goals, but impact claims remain difficult to verify, and a fund which raises concessional capital on the strength of its ESG purpose must be able to show that the purpose is real. Grant capital raises separate questions under FCRA where it comes from foreign sources, and its accounting must remain distinct throughout the life of the fund.
Closing Note
The September 2026 framework does not abandon investor protection. It changes its basis from equal treatment to equal information. For fund managers, that brings real opportunity, particularly for impact and ESG funds which have long struggled to bring commercial investors alongside those willing to take more risk. However, it also moves the burden onto the documents. The quality of the placement memorandum, the clarity of the waterfall and the independence of the valuation will now determine whether junior investors are treated fairly. Fund managers considering the framework should therefore treat it as a drafting exercise as much as a regulatory one. And as GIFT IFSC and the onshore market continue to diverge, the choice between them will turn less on which regime is more permissive than on which one suits the investors a particular fund is seeking to bring together.
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