Small but Mighty: The Rapid Rise of SME Direct Lending
Small and medium enterprises (“SMEs”)* account for most employment and business activity across Europe and the UK, yet remain structurally underserved by banks.
As banks pull back and mid-market direct lending becomes more competitive, SME direct lending is emerging as a distinct and scalable opportunity for private credit funds. The combination of funding gaps, better structural protection, and political support makes it one of the clearer growth areas in the asset class.
1. Why SME direct lending is accelerating
Structural pull-back from banks
OECD data showed a 9% drop in SME bank lending in 2023, the sharpest contraction since the financial crisis, alongside materially higher borrowing costs. UK data echoes this: SME lending volumes of c. £60bn in 2023–24 represented a 15% decline in real terms. Challenger banks now originate nearly 60% of new loans - evidence of demand outstripping traditional channels.
LP demand for diversification
According to Private Debt Investor’s H1 2025 survey, 75% of LPs feel underallocated to private debt. Many are rotating away from crowded unitranche deals, where leverage, refinancing risk and PIK usage have increased, and towards lending with tighter covenants and more visibility on cashflows. SME lending fits this shift well.
Policy support
The European Investment Fund (EIF) now directs over 40% of its activity to SME-focused programmes. In the UK, the British Business Bank continues to expand guarantee schemes and co-investment support aimed at smaller borrowers. This institutional support lowers risk and accelerates capital deployment.
2. What SME lending offers investors
Stronger structures
SME loans typically include 2–3 covenants and asset-based security, contrasting sharply with the single-covenant or covenant-lite documentation common in larger sponsor-backed deals in the mid-market. This gives lenders earlier warning of stress and more levers to manage downside.
Augmented returns
Lack of competition in the SME lending market means that lenders can command higher IRRs at a similar level of risk to larger deals. Additionally, leading managers are frequently able to negotiate equity kickers for their SME loans - Beechbrook cites usage in up to 90% of transactions - which bolsters returns and provides additional upside.
Lower correlation to buyout cycles
Because SME borrowers are owner-managed rather than PE-owned, their performance depends on local demand and recurring revenues rather than private equity refinancing cycles. This gives investors exposure to a different set of return drivers and helps reduce concentration in sponsor-backed lending.
3. The drawbacks: where the risks lie
Scaling constraints
Investor demand for SME direct lending is strong, but only a limited number of managers have the underwriting bandwidth and monitoring capability to deploy capital without eroding their standards. Rapid AUM growth can pressure managers to loosen credit discipline, which is a key risk in this part of the market.
Operational intensity
Because SMEs typically have weaker operational and financial infrastructure, lenders require monthly financials, more frequent covenant testing and closer monitoring to detect issues early.
Macro sensitivity
SMEs absorb shocks quickly - sudden jumps in energy costs, wage inflation and working-capital all hit their cashflows hard. OECD surveys show that roughly one in four SMEs consistently face financing constraints. Credit selection, sector bets, and covenant design matter more with SMEs than in broadly syndicated lending.
4. Conclusion
SME direct lending can offer stronger protection and more resilient credit performance than crowded mid-market sponsor lending, but requires hands-on monitoring and disciplined underwriting to manage volatility and scale constraints.
Sources: PDI: Does SME lending tick the boxes? (2025); OECD Financing SMEs & Entrepreneurs 2024; EIF Annual Report 2024; British Business Bank Small Business Finance Markets 2023/24; Preqin Private Debt Outlook 2025
