After a long hiatus, optimism returned to the deal markets in the early part of the year. Companies were hiring, stocks were rising, and the price of debt was falling. Merger and acquisition activity responded in kind, jumping almost 50% in the first quarter of 2010, compared to the same period one year ago, according to CapitalIQ.

But the optimism was short-lived. Touched off by Greece's debt crisis, fears about the fiscal health of other European countries spread to the rest of the world, eroding confidence in aneconomic recovery. Volatility returned to the stock market, the price of debt began to climb, and what had looked like a fecund environment for dealmaking suddenly turned fallow, exemplified by the collapse in May of a contemplated $15 billion acquisition of payment processor Fidelity National Information Services Inc. by a consortium of private equity firms.

"It was a party," says Howard Lanser, head of the debt advisory business of Milwaukee-based investment bank ­Robert W. Baird & Co. "But then we had a party crasher called Europe."

But there's at least one sector in which optimism still reigns -- the middle market. For companies with less than $50 million of Ebitda -- the bulk of the corporate economy -- M&A and financing activity continue to chug along, somewhat offsetting the doom and gloom that has taken hold of the markets' psyche in recent weeks. Fueling the activity are private equity firms that are under pressure to both sell portfolio companies in order to lock in gains and to buy new ones to put their unused capital to work.

Financing in the middle market is also relatively robust as more lenders seek to invest in debt with higher yields than what's currently available in the larger corporate market.

"It's a Goldilocks environment," says Durant "Randy" Schwimmer, head of capital markets at Churchill Financial LLC, a New York-based midmarket lender. "You have good dealflow, but not crazy dealflow. We're seeing reasonable structures with decent pricing for what are, generally speaking, great credits."

Of course, the middle market's optimism comes with a fair share of caveats. Many participants say that much of this year's financing activity is tied to broader, but temporary, trends and warn that even though they are gearing up for a very busy fall and winter, the positive effect of those trends will likely fade by the beginning of next year, especially if the broader economy continues to struggle. But for the rest of 2010 at least, the outlook is bright.

The middle market isn't a monolithic space. While it's most commonly defined as companies with between $5 million and $50 million of Ebitda, there's a wide range between the smallest members, which are often family-owned, and those on the verge of crossing the Ebitda upper limit. Middle-market lender CIT Group Inc., citing U.S. Census data from 2000, says that middle-market companies accounted for more than $6 trillion in sales and employed about 32 million people, more than twice the revenue and 4 times the number of employees of the largest-cap companies that compose the Dow Jones industrial average.

Although the number of lenders to the middle market has declined in recent years, thanks to the disappearance of major players such as Wachovia Corp., which was acquired by Wells Fargo & Co. last year, and Merrill Lynch & Co.'s middle-market unit, Merrill Lynch Capital, which was absorbed by rival GE Capital Corp. in 2007, a wide variety of lenders still service the sector. Specialty finance companies GE Capital, CIT Group and Churchill Financial, as well as banks such as Bank of America Corp., Wells Fargo and SunTrust Banks Inc., provide senior debt and subordinated (and more expensive) mezzanine structures. Business development companies with permanent capital, such as Ares Capital Corp. and Golub Capital Partners LLC, along with hedge funds such as D.E. Shaw & Co. LLP and FrontPoint Partners LLC, also lend money to middle-market companies, viewing the loans as attractive because they yield more than corporate debt to larger companies.

Since the turn of the year, financing activity in the middle market has picked up, owing to an increase in dealmaking. As economic uncertainty has sent many large corporate buyers to the sidelines and kept private equity firms from making aggressive bids for larger companies, middle-market dealmaking has accounted for a larger share of the M&A pie. According to Robert W. Baird & Co., middle-market M&A composed about 30% of total deal volume in the peak year of 2007. That rose to 37.5% in 2008 and hit 43% in the first quarter of this year.

Financing volumes have risen in kind. According to Standard & Poor's Leveraged Commentary & Data unit, new-­issue midmarket loan volume for the first half of this year totaled $5.7 billion. That compares with none last year, the nadir of the post-Lehman Brothers Holdings Inc. bankruptcy credit crunch. Of this year's total, $3.6 billion was issued in the second quarter, the highest quarterly number since the $4 billion issued in the first quarter of 2008.

That's a long way from the peak credit boom years, when more than double those amounts were being done in comparable time frames. But few expect the 2005 to 2007 era to be replicated any time soon. "2007 should not be the benchmark," says Lawrence Golub, president of Golub Capital, one of the larger lenders in the sector, with more than $4 billion in capital.

Golub notes that recent worries about the economy have caused average spreads for middle-market loans to widen by 100 basis points in the past few weeks, and lenders are now asking for stricter terms, including call protection of one to two years. LIBOR floors -- the minimum base level used to calculate floating interest rates on the debt -- have risen some 50 basis points, to around 200 basis points, he adds.

Still, Golub says things are not that bad. "Senior debt pricing is now still lower than it was six months ago," he says.

According to LCD, the average loan spread in the second quarter was LIBOR plus 477 basis points, almost a full percentage point tighter than the 2009 average of LIBOR plus 564 basis points. But some recent deals suggest that spreads could continue to increase. For example, Golub Capital on July 8 raised pricing on software company Syncsort Inc. from LIBOR plus 500 to LIBOR plus 550 with a 2% LIBOR floor. According to LCD, it was the third deal to raise pricing in early July, including financing for software company Vision Solutions Inc. and Hearthside Food Solutions LLC, which both saw prices of their loans increase from LIBOR plus 500 to LIBOR plus 600.

At least one investor sees the rising debt prices as a normalization following a stretch that was arguably too robust for fundamentals. "People got out too far in front of their skis," this investor says.

But there are other factors at work. The price of debt has also been increasing due to a retreat by suddenly risk-averse investors from high-yield bonds. The market for subordinated debt boomed in 2009 and through early 2010, and many companies took the opportunity to restructure their balance sheets and refinance maturing loans with longer-­dated bonds.

That put cash into the hands of loan investors, particularly the collateralized loan obligation funds that made up 66% of the demand for senior debt at the height of the credit bubble. Because CLOs get no return from cash, their managers have had a strong incentive to take the money returned to them via refinancings and recycle it into new loans. Much of that activity has been taking place in the middle market.

But recent volatility has caused investors in high-yield bonds to reassess. According to data from Lipper FMI, high-yield mutual funds have suffered outflows in eight of the past 10 weeks, losing $3.46 billion. Money flowed out of those funds in 11 of the first 27 weeks of this year. All of this is causing refinancing activity to slow, and with that spigot turned off, any CLOs with cash are handling it carefully, causing borrowers to make their offerings more enticing to attract buyers.

That said, there are still some lenders willing to jump into the breach. "The midmarket is one of the few places where you can still get an illiquidity premium," says S&P managing director Steven Miller. Mike Zupon, former head of the leveraged finance group at Carlyle Group and co-founder of debt investing firm Sound Harbor Partners LLC, says that lenders can afford to be picky these days, which ensures that only the strongest credits are finding lenders.

"The deals that should get done are getting done," he says.

Given the favorable environment for lenders, the past few months have seen the ramping up of several funds with new capital to invest in the middle market. Take, for example, healthcare-focused MidCap Financial LLC, formed in late 2008 with $500 million in equity from Thomas H. Lee's Lee Equity Partners LLC, Genstar Capital LLC and Moelis Capital Partners LLC. (See article on page 42.) On July 7, MidCap announced it had received a $250 million credit facility from a group of banks led by Wells Fargo for expanding its lending.

Hedge fund FrontPoint Partners in March hired a new investment team, led by the former head of mezzanine finance at Credit Suisse Group, Stephen Czech, to originate and invest in loans to midsized businesses.

The recent influx of funds into the middle market isn't surprising, given the dissolution of several longtime lenders to the sector. Those firms' displaced investors are trying to find ways back in. MidCap Financial co-founder and CEO Howard Widra, for example, hails from Merrill Lynch Capital's healthcare finance business and founded MidCap soon after GE Capital bought the unit. Last May, the founders of Merrill Lynch Capital, Robert Radway, Mike Litwin and Neil Rudd, formed NXT Capital LLC, a Chicago lender backed by private equity firm Stone Point Capital LLC. NXT completed its first deal in April.

The amount of capital the funds represent is a fraction of what was raised during the 2005-2007 period, when CLOs represented more than two-thirds of investment in the then-booming loan markets. In fact, since the beginning of 2008, there's been virtually no new CLO creation, aside from a few refinancings, which has left a large gap in supply. "There's not as much capital available as there's need for it," says MidCap's Widra.

And demand is almost certainly set to increase. A co-head of M&A at a middle-market investment bank says the rest of 2010 may feature a spike in midmarket M&A, prodded by private equity firms that are looking to sell strong investments and book gains ahead of capital gains tax increases scheduled to take effect in 2011. Those rates are set to increase from 15% to more than 20% on Jan. 1 as Bush-era tax cuts lapse.

Those sellers likely won't have to search far for buyers. According to consulting firm Cambridge Associates LLC, private equity firms that raised money in the last investment cycle are sitting on about $425 billion of unspent capital. Many of those funds are facing the end of a five-year investment period, and they must hurry to put that money to work if they don't want to return it to their limited partners.

It has all the makings of a frantic second half of 2010 for deal-related financing. "We've canceled Christmas vacation this year," says Golub. "People will be working right up until midnight on Dec. 31, trying to finish deals."

One banker says that anyone looking to sell a business within the next couple of years is already being pitched a quick sale now, and it is unlikely that anyone who is contemplating a sale within the next two years won't be pressured into doing a deal as soon as possible.

The expected flood of activity could present problems for dealmakers, says Bob Hotz, co-head of corporate finance at Houlihan, Lokey, Howard & Zukin Inc., a middle-market-focused investment bank. "It won't be as much a question of the availability of money as much as about processing power," he says, explaining that banks, law firms and lenders could struggle to get all the deals through the pipeline by the end of the year. This could force lenders to choose between deals and will likely give an advantage to higher-rated borrowers.

In the absence of a broader recovery, front-loading all of the dealmaking into this year probably means that financing activity could slow to a crawl in the early part of next year. "There will be a lot of time to catch up on sleep in 2011," Golub says.

Hotz says that wouldn't be so bad. With less activity in the market, borrowers might be able to get better terms from lenders who have few options to put their money to work, and sellers may be able to command better terms from buyers when fewer companies are on the block.

"Missing this year may not be the worst thing in the world," he says.

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