Since mezzanine loans provide both borrowers and lenders with attractive cost and return ratios, mezzanine financing can be a great option. Yet, everyone involved must understand all of the risks entails in mezzanine to make sure it is the right fit for their portfolio.

Mezzanine debt investors are at the mercy of senior debt and equity investors in terms risk. Thus, their vulnerability goes up when markets are in an unstable state or the economy is crashing.

High Leverage.

Mezzanine debt rates less, returns more than equity financing and is a suitable debt for a company with high growth goals. It is also more flexible than preferred equity and typically has equity upside vested in warrants or convertible options. Additionally, the lender can even deduct interest on taxes as an extra tax deduction today in a low tax environment.

Most companies that are stuck between equity and senior debt, whether it be undervalued fixed assets that will never sell or bank lending requirements that make it impossible to raise enough debt, mezzanine funding is the solution that helps remove this funding bottleneck so that they can pursue strategic initiatives without adversely affecting equity value or return.

Uncertainty in Market Conditions.

The use of mezzanine financing is allowed only if it comes with a clear-cut intent and strategy for its investment. Mezzanine is a great fit for companies with mature debt that does not meet senior debt requirements or equity funding limits, and who need some help getting to the next stage of growth.

Mezzanine loans require future cash flow to be repaid, making it harder to get the loan paid back during economic contraction or markets insufficiency. Furthermore, mezzanine lenders may need warrants to convert debt into equity – possibly undermining shareholder ownership if warrants or something similar have to be issued – so a correct valuation analysis is important for lenders and borrowers alike.

Restrictive Covenants.

Because mezzanine financing is a means between equity and senior debt financing, it often has strict covenants dictating the ways in which a company can expand – from restrictions on the size of its stock offering to the disposition of cash flow from operations.

Mezzanine loans are typically more costly because of their higher risk. They can also contain equity backed by lenders upside opportunities such as warrants (the right to purchase equity at a certain price within a defined time period) or a debt-to-equity convertible.

In researching mezzanine lenders, look for those who have a lot of experience and a track record in your sector. If you choose a good lender, then there are risks of this funding.

Obligatory High Interest Rates.

It’s often higher rates of return required by mezzanine lenders to commit themselves to additional risk. They will look at a business’ past financial performance and future prospects before funding, and may ask to see a detailed business plan on how the loan will be spent.

Because mezzanine debt is junior and has no preference to the senior debt, should there be a liquidation, mezzanine investors could possibly lose all invested capital if no assets were left to cover all the debts.

Mezzanine debt often features payment-in-kind (PIK) interest, thereby managing risk by permitting the company to pay their interest in cash, equity or both – making borrowers more agile in their cash positions and managing cash flow easier.

Conversion Rights.

Businesses may have to raise mezzanine loans to bridge a gaping funding hole due to unallocated fixed assets that cannot appreciate or limits on how much debt can be borrowed from the bank.

Mezzanine loans can even contain conversion rights allowing investors to convert the mezzanine debt to shares in the borrowers through warrants or other obligations with high return on investment if their business grows.

Investors who own mezzanine debt have to conduct rigorous research on a company that they are thinking about investing in before risking money. That includes an assessment of its credit rating, management, competitive position and growth potential before putting their capital at stake – even in bankruptcy risk since senior creditors will first cover their losses by disposing of its assets.