Not even a trickle

In some economic downturns, middle markets manage to escape the worst of the carnage. This doesn't look like one of them.

The credit crunch has been "upgraded" to a full-fledged recession and now appears that it may be lashing the sector even harder -- by some reports -- than the market at large. Take October's numbers, when overall U.S. deal volume was down 21% on a year-to-year basis. Middle markets were down 59%.

In November, the difference was negligible in a broadly terrible month: overall U.S. deal volume fell 87% to 80% for middle markets.

Just how bad are things? One dealmaker in the middle market sums it up: "October was an incredibly difficult month. November was even worse." The good news? At least this middle market dealmaker isn't anticipating things to disintegrate from here. December, he says, will be "equally bleak."

If that's an optimistic prediction, we'll take it. Then again, it's hard to see how the situation could disintegrate much further. Dealmaking volume is literally a fraction of what it was a year ago (when it wasn't good, either). One reason November's retrenchment in the middle markets was on par with the broader market's was likely the fact that October's was so pronounced. Think about it: a 60% drop followed by an 80% reduction? That doesn't leave much left.

We all know how we got here (housing downturn, mortgage meltdown, credit crisis, etc., etc., ad nauseam). But why has the situation specifically in the middle market deteriorated so badly?

Four words: It's the economy, stupid. Earlier this year, when loan markets seized up and LIBOR spiked, middle-market dealmaking managed to (somewhat) chug along due to the smaller size of its transactions and their larger proportions of equity and cash. That might have continued, too, had the world economy played along. Alas, it didn't -- and really, how could it? Now that we're in a recession, the impact is nothing short of dramatic. The source says the fourth quarter of 2008 could go down as one of the all-time worst in the history of middle-market M&A.

"Banks are very reluctant to lend with the money given to them by the feds," he says. "We've seen this trickle down to the consumer, where credit has tightened and credit card companies are pulling back. It's a tsunami of a deteriorating economy and tightening credit."

The problem, then, is no longer even one of liquidity. Cash to finance deals -- small deals, at least -- is either there to be had or in place already. The banking system seems to have been saved. It's been largely nationalized, but it's safe for now. The immediate danger of a bank run has been halted. Despite this, lending has not picked up. In fact, it has continued to tighten. A crisis of confidence? "Fear has completely enveloped the market," says the source. "You have stabilization. Now you need action."

It's not all the banks, either, which on many levels cannot be faulted for wanting to use the government money to stabilize their own balance sheets. Private markets are stuck at an impasse, with buyers and sellers at a disconnect over how to value businesses in light of the meltdown in public markets.

"Owners, existing investors, management, boards don't feel like the public sector is rational today and that the valuations in the public markets shouldn't be applicable," says a different source, this one on the private equity side. "It's a very difficult environment where people are saying their companies should sell for up to a 300% premium on the public market. ... People just haven't accepted that this is what companies are worth at this time." In many cases management decides there is a higher likelihood it will get a better valuation in a few years' time and agrees to wait it out.

To get dealflow moving, public markets must change, or private companies need to get a better grasp of what's going on and become more rational. Or more desperate. That could happen eventually, but it isn't likely to occur right away. This is one reason an immediate recovery isn't likely.

The other, larger issue is Mr. and Mrs. Consumer, who are even further removed from putting their cash back into the markets. For this to happen, the federal government's actions need to work. Most economists expect this to happen no sooner than the second half of 2009. Once it does, dealmaking will likely be led by well-capitalized strategics buying small companies and troubled rivals. Until then? "From our perspective, we think we're coming near a bottom if we haven't already hit it," says the dealmaker source. "But the first half of 2009 is going to be very difficult."