NRD,
I have often pondered this myself & reckon it could perhaps be made to work if you put a roller under the swingarm pivot w the return run of the chain going under (not over) that roller. It could then be made somewhat akin to the early 'paralelogram' ATK system, w the advantage of the suspension being somewhat independant of the torque reaction when you apply the power, & would be somewhat self-correcting on chain slack if you got the position of that roller right.
Something sort of along those lines is described in Motorcycle Design & Technology as the "tracklever" system
I have seen an XL engine in a Bultaco frame like what you describe (tho probably more than 25mm). I don't know what it rode like on a track, but I would think you'd have real probs w chain tension if you didn't do something like I suggest above.
