Do You Even Want to Know?

In the first two weeks of November, Richard Wottrich of Dresner Partners, lined up three new mandates. During that same month, right around the same time, Harris Williams & Co.'s William Roman finalized the sale of Barker Company, completing a process that had been put on hold earlier in the year. They may seem like small victories, but for a market starved for optimism, these can be the building blocks of a rebound.

Going into 2010, nobody is quite sure what to expect. Visibility has improved, but uncertainty around the debt markets and growing macroeconomic concerns are preventing anyone from becoming too bullish.

Last year, certain events were hailed as signs the M&A market was regaining its feet. Warner Chilcott, in August, lined up $4 billion of financing for its $3.1 billion acquisition of P&G's pharma business. The leveraged loan markets, apparently, had bounced back. Data Domain, in July, was at the center of a battle that had rivals bidding up the assets in a defensive chicken match. This was billed as another good sign. There was even hope for private equity, as Blackstone Group plunked down $2.7 billion to buy InBev's SeaWorld and Busch Gardens parks business, a deal that closely followed Silver Lake's $2 billion Skype acquisition. The LBO market had rediscovered its juice.

Except none of this really had any bearing on the middle market. Moreover, as 2009 trudged along, many of these positive signs proved to be either isolated events or not worthy of the significance placed on them. If there is a consensus about next year, it's a collective shrug about what comes next.

"There will be activity," Dresner's Wottrich, a managing director at the firm, maintains. "But you have to ask, 'What is the quality and why are deals getting done?'"

Wottrich says he has seen a lot of "flash and motion" in the middle market, much of it driven by "wreckage from the recession." Whether or not that changes, he adds, depends on a lot of things. The implosion of Dubai World in late November, though, seems to imply that lingering aftershocks will be a way of life for the foreseeable future.

Most dealmakers are at least confident that the market has nowhere left to go but up. That's not necessarily a ringing endorsement, as 2009 was one of the worst years on record for the decade. Only 4,660 domestic deals were completed last year, according to Thomson Reuters, 20% lower than the next smallest sum logged in 2002.

The primary issue slowing deal activity has largely eased, at least temporarily. Companies and investors have regained visibility into their businesses and markets. That alone should allow them to move forward with a strategy, whether the updated plan translates into more cost cutting or a renewed pursuit of growth.

On the sell side, the past 12 months have been a waiting game. "More recently, we've been focused on cleaning up companies. We're prepping them for the types things buyers will notice, whether it's getting rid of contingent liabilities, settling nuisance suits or employee issues, or making sure the management team in place," Patrick Goy, a managing director at Lincoln International, describes.

This new attention to detail is driven by a couple of factors, one of which, no doubt, is that companies have the time to do the prep work. The other factor, according to Goy, is that he is actually anticipating a rush to market in early 2010. "We've been telling companies to be patient, but after the first of the year, they should be ready, because the market is going to become a lot more cluttered by April and May."

Asset sales, should visibility continue to improve, will come from all directions. Private equity firms have a backlog of properties that have put off exits for at least two years; family-owned businesses, with an eye still trained on the favorable but lapsing capital gains treatment, have also delayed sales; and corporate entities, armed with a clearer view into their own business, will realign to focus on only the most promising segments, which translates into divestitures. Distress too, will not be overlooked, as the re-equitization -- or deleveraging -- of Corporate America will provide ongoing opportunities for acquirers.

The buy side, meanwhile, has as many drivers, although bankers are largely expecting strategic acquirers to stand out in 2010.

"In the first quarter," Harris William's Roman says, "visibility was so bad, that companies started cutting without really knowing how deep they had to go. In hindsight, many have realized that they went a lot deeper than they had to."

The cost cutting, in many cases, has resulted in earnings improvement. The next logical step will be the renewed pursuit of top line growth. "Economic expansion is expected to be anemic," says Moelis & Co.'s Jeff Raich, a managing director and co-founder at the firm. In the absence of organic growth, "real bread and butter M&A" -- be it horizontal consolidations or vertical deals designed to bolster product lines -- will be the easiest way to goose revenue.

"Companies are generating a tremendous amount of cash," Michael McFadden, co-chief executive at Lazard Middle Market, adds. "We've seen margin growth and improved stock prices, so from a currency standpoint, many of them are in a position to be buyers in this market."

Wottrich notes that "the big boys," such as Kraft, Hewlett Packard, 3M and others, have been "hording" capital, making them likely suspects to be buyers in 2010.

In the mid-market, however, the buyers may not be as obvious. The profiles of those pursuing deals will likely resemble names like DynCorp International or Harris Corp. DynCorp, for instance, has a cash balance of $132 million, and another $170 million undrawn in a revolver. The defense company inked its first deal in October, buying Phoenix Consulting Group and hinted that new deals would be forthcoming. Harris, which has a longer history in the deal market, acquired Tyco Electronics' wireless systems business in August, paying $675 million, and followed that up with a deal in November to acquire Patriot Technologies, a healthcare IT provider serving the municipal market. Harris has roughly $230 million of cash available, and nearly $750 million undrawn on its revolver. The common threads, of course, are a healthy balance sheet and a mandate to diversify.

Cross-border activity will also be in focus in 2010. Wottrich, who cites that China will remain to be the "center of the world" next year, says he is expecting to see a significant amount of dealflow emanating from overseas. This trend represents more of a continuation of past activity. Caterpillar, in the last week of November, for instance, acquired South Korean undercarriage component manufacturer JCS Co., while Avnet Inc. bought Vietnamese IT distributor Sunshine Joint Stock Co. Both transactions build on previous efforts in the respective markets.

Most dealmakers are in agreement that 2010 will be the year of the strategic buyer. This is largely because private equity investors will continue to be hamstrung by the impaired debt markets. Onlookers, however, are well aware that there is a fuse on the billions of dollars of uninvested capital that sponsors still have at their disposal. Also, while the asset class certainly shares some blame for leveraging up Corporate America, sponsors will be counted on to play a role in the re-equitization plays that will only become more common. This may take the form of PIPEs and structured investments, such as BC Partner's late June investment in Office Depot, or it could more simply be investments in distressed assets that require an equity solution.

There will also be some scrambling to put capital to work. Moelis' Raich, for instance, anticipates even more compression in the market, as mega firms chase after smaller companies. This, he says, will reverberate throughout the entire market. "Those $30 billion Harrah's LBOs aren't coming back. The larger firms are going to be dipping into the middle market and they'll be over-equitizing transactions, buying companies with an eye on holding them for a five- to seven-year period."

Then there are the funds whose investment windows are nearing their close. In 2004 and 2005, for instance, nearly $225 billion of new capital was raised. While much of that was spent during the boom, it is also likely that a good portion of those funds still have dry powder and have either already passed or are hitting the five-year mark -- the point at which funds are expected to have deployed the capital. "Many groups still have a significant warchest that they have to put to work," McFadden notes. "This is a big factor in the demand we're seeing."

So what will a recovery look like? Few even want to guess at this point. A standard answer from bankers is that nobody will realize the market has turned until three to six months after it already happened.

And many bankers aren't necessarily comfortable with the premise that a recovery will occur in 2010. Wottrich, for instance, warns, "To me, the dollar is a big ticking time bomb. Rates are artificially low and the rest of the world is becoming impatient. We haven't been doing anything but printing money, so we're going to have to face higher interest rates and inflation."

He also points to the unemployment rate, hovering around 10%, which will continue to drag on the economy. "It's hard to see where productivity is going to come from," Wottrich adds.

The other big unknown involves the credit markets. The refi cliff, with more than $800 billion in debt set to mature in the next five years, is on everyone's mind, and the commercial real estate market is perhaps facing the same kind of crisis that the subprime mortgage market confronted in 2007.

It's these threats that had the M&A markets gravitating toward insulated industries -- be it healthcare, education or technology, which seemed to account for most of the activity in 2009. "A sign of health," Raich identifies, "will be when the concentration of activity evolves to the point where there is broad participation across many sectors."

But even Raich, an optimist, won't state definitively that this will happen in 2010.