How Interest Rate Movements Impact Private Equity Valuations
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 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 lending is accelerating
Structural pull-back from banks
OECD data shows 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% real-terms decline. 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 specifically at smaller borrowers. This institutional support lowers risk and accelerates capital formation.
2. What SME lending offers investors
Stronger structures
SME loans typically include 2–3 covenants and asset-level security, contrasting sharply with the single-covenant or covenant-lite documentation common in larger mid-market sponsor deals. This gives lenders earlier warning of stress and more levers to manage downside.
Return asymmetry
Leading managers are frequently able to negotiate equity kickers for their SME loans - Beechbrook cites usage in up to 90% of transactions – supporting low double-digit total returns even when cash yields sit in the high single digits.
Lower correlation to buyout cycles
Because SMEs are often owner-managed, returns are tied to local demand and recurring revenue rather than private equity refinancing cycles. This diversifies sponsor-heavy portfolios, especially in periods when exit markets remain slow.
3. The drawbacks: where the risk sits
Operational intensity
The granular nature of SME origination means more frequent monitoring, tighter data needs, and more active workout capabilities. The model works only when platforms invest in underwriting discipline and resourcing.
Macro sensitivity
SMEs absorb shocks quickly - energy costs, wage inflation and working-capital swings all hit their cashflows. OECD surveys show that roughly one in four SMEs consistently face financing constraints. Credit selection, sector tilts and covenant design matter more here than in broadly syndicated lending.
Scaling constraints
The limiting factor is not LP appetite but manager capacity. Institutional-quality SME lenders remain relatively few; several sources note that large inflows can erode discipline if vehicles grow faster than origination quality allows.
4. What LPs and GPs should focus on
For GPs:
Define your niche precisely (size, geography, sectors).
Invest in monitoring and workout capability.
Avoid scaling faster than origination quality allows.
For LPs:
Underwrite origination channels and historical recoveries.
Understand how equity participation is structured.
Map correlations: SME exposure diversifies sponsor risk but remains linked to real-economy shocks.
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
