While the bond markets have been buffeted by volatility in recent months, private markets such as mezzanine debt have come into their own and impressed investors with their flexibility.

Mezzanine debt has long been used by mid-cap companies in Europe and the US as a funding alternative to high yield bonds or bank debt. The product ranks between senior bank debt and equity in a company's capital structure, and mezzanine investors take higher risks than bond buyers but are rewarded with equity-like returns averaging between 15 and 20 per cent.

Companies that are too small to tap the bond market have been the traditional users of mezzanine debt, but it is increasingly being used as part of the financing package for larger leveraged acquisition deals. Although mezzanine has been more expensive for companies to use than junk bonds, the recent spread widening in the high yield debt markets has closed this source of funding and has made mezzanine look better value.

The mezzanine debt market has flourished this year, confounding fears that developments in other parts of the capital markets would render it obsolete.

"There has been a lot of hype over the past few years about high yield bonds crowding out mezzanine debt, but now the situation is reversing," says Simon Collins, head of debt advisory services at KPMG. He favours a deepening of the mezzanine market, so that larger amounts can be raised there when high yield markets shut down.

The structures of leveraged finance transactions are evolving to cope with the increased market volatility, and a greater use of mezzanine debt is part of this trend.

"Evidence of the recent glitch in the high yield bond market and its replacement by mezzanine debt may take a while to see," says Tom Attwood, managing director of Intermediate Capital Group. "They are both perfectly valid forms of funding for leveraged transactions, but the high yield market is not always open."

The characteristics of the mezzanine market make it well-suited to LBO deals - money can be raised quickly and discreetly as companies negotiate directly with mezzanine funds. "There are inherent advantages to using mezzanine over high yield bonds. It is more flexible, offers better call protection and can be structured specifically for each deal," says Mark Brunault, executive director at Pricoa.

New investors are being drawn to the European mezzanine market in search of higher returns, as illustrated by the burgeoning number of new funds established this year. In July, Mezzanine Management raised one the largest independent mezzanine funds in the European market, worth $525m. Its first investment was a $12m mezzanine finance and equity injection into UK media monitoring company Xtreme Information.

Intermediate Capital Group launched a E465m mezzanine fund in September, as well as a second European collateralised debt obligation vehicle worth E350m that includes mezzanine in its investment strategy. The majority of ICG's investments are now made in continental Europe, because the UK is becoming a mature market. ICG's recent investments include a DM200m mezzanine facility for Takko, the German retailer bought out in March from Tengleman group.

ICG was closely followed by Pricoa, which closed its PPCP II fund at end of September. The capital available for investment totals E540m, E340m of investor commitments and E200m of medium-term bank debt from Bank of Scotland. As well as the specialist players the market is also populated by investment banks, building mezzanine debt capabilities as part of their one-stop-shop strategy in corporate finance.

Many of the funds in the mezzanine market are cash rich, because of the popularity of the product and due to the current lack of major investment opportunities. However, many of the leveraged finance deals in the pipeline, including several UK public-to-private transactions, are using mezzanine rather than bridge loans or high yield bonds and the deal flow should soon pick up.

Mezzanine fund managers are unlikely to rush into deals, though, having recently been reminded of the risks involved in the mezzanine market. At the start of October Finelist, the car parts distributer that was bought by French rival Autodis in March, went into receivership. The E505m buy-out had been financed with leveraged loans and E275m of mezzanine debt, and had been one of the largest deals in the European mezzanine market.

Finelist's collapse was triggered when it broke financial covenants on its debt, and receivers Ernst & Young have since been readying the business for sale and looking into allegations of financial irregularities. While the bank lenders have a good chance of recovering their money, the mezzanine lenders risk losing their subordinated investment. Goldman Sachs, which arranged the buy-out's financing, is thought to hold more than half of the imperilled mezzanine debt in its Mezzanine Partners II fund.