Mezzanine funding may not initially sound like an obvious or likely form of financing for small and medium-sized enterprises (SMEs). Arguably, in popular business imagination the funding model conjures up images of expensive, high-geared debt associated with aggressive and sizeable leveraged buy-outs.

However, across the EU, mezzanine (which can be broadly defined as a cross between equity and debt finance) is increasingly being viewed as one of the more appropriate forms of funding for SMEs. In the wake of the credit crunch many smaller companies are still struggling to raise finance. They are either too small to access high-yield capital markets or are affected by a general unwillingness by the banks to lend.

Related: How mezzanine finance can help ambitious SMEs to grow

According to the government-commissioned Rowlands Growth Capital Review, which assessed the finance options for SMEs, there is a funding gap that affects some 5,000 SMEs seeking between £2 million and £10 million.

Interestingly, the review drew two further conclusions. The first was neither bank lending nor equity investors are likely to fill this SME funding gap. Secondly, the availability of mezzanine funding is key to meeting the needs of SMEs.

The review’s case for mezzanine financing is it provides an alternative source of capital for businesses that would not attract equity investment or are inappropriate for debt finance mostly due to a lack of available of collateral. In addition, mezzanine helps address the reluctance among many SMEs to part with equity, which the report also notes.

Another reason is that the cost of mezzanine finance for SMEs is lower than for pure equity, partly because interest payments are tax-deductible. Mezzanine lenders generally focus more on the total return of the investment over the life of the debt. They are less concerned with collateral or short-term earnings fluctuations.

In fact, as a subordinated and unsecured debt, it has some features in common with a senior class of equity, and most senior lenders consider a company to have strengthened its balance sheet by adding a layer of mezzanine capital.

Most SMEs have financing needs of no more than £1.5 million to £1.7 million and until relatively recently, funds providing mezzanine debt focused on transactions of above £10 million. But more recently a number of mezzanine funds have emerged that focused on small- to lower-mid-caps, offering advances of between £15,000 and £5 million that could be suitable for the needs of SMEs.

Generally, these funds are willing to look at any SME that exhibits the following characteristics: an established business with sustainable operating profits and positive cash generation; operating in a growth market with a strong defensible position in relation to its competitors; and, generating strong margins with a scalable business model.

What will drive the growth in mezzanine funds dedicated to SME financing is the co-investment model many new entrants have developed with regional development agencies, government bodies such as Capital for Enterprise, and EU bodies such as the European Investment Fund. Increasingly, such organisations are concentrating on making mezzanine debt available to SMEs.

This trend is resulting in a shift of emphasis away from classic bank mezzanine to a more risk-orientated mezzanine type of financing, more akin to venture capital. The change in attitude is demonstrated by the fact that some funds are no longer content with the traditional role of the passive mezzanine lender, offering instead to partner their own investment teams with the management of the SME receiving finance.

That shift, combined with a renewed interest in the model in general, means that mezzanine funding is playing an increasing role in closing the funding gap.

See also: Understanding Mezzanine Finance