The private equity market is feeling a pinch these days as evidenced by the lowest deal volume to date in years. Additionally, the total dollars going into private equity funds is hovering about $50 billion, which is also the lowest it’s been in years. It’s highly unlikely that fundraising in 2008 will come close to hitting the record $300 billion that was raised in 2007. However, perhaps the story of 2008 will not be about the total volume but rather the number of separate funds raised.

Last year, funds in excess of $5 billion accounted for roughly $150 billion of the total funds raised, while $1 billion-plus vehicles accounted for about $100 billion. 2008, in contrast, seems to be the year of the middle market. With an inability to leverage deals in today’s market, most large generalist funds will undoubtedly be on the sidelines and might have difficulty rationalizing to LPs the necessity of so much capital. Kohlberg Kravis Roberts, at the end of March, decided to end its nearly two-year marketing effort for its KKR 2006 fund, settling at $17.6 billion.

“If you rely on the syndicated debt market to make money, then now is not a good time to be out there,” according to one middle market buyout pro, who is in the midst of raising his firm’s second fund. “However,” the source adds, “it’s a great time to raise funds because it’s a great time to have liquidity and a great time to be buying. When you have a model for buying at a good value and you have a niche value proposition, then there’s money available.”

Case in point, the $167 billion California State Teachers’ Retirement System (CalSTRS) recently hired Invesco Private Capital for a private equity fund-of-funds mandate. The fund, called the New and Next Generation Manager Fund II, will focus on middle-market private equity firms trying to raise their first, second or third institutional funds. CalSTRS’ $200 million will be invested over a five-year period.

Kevin Scanlan, the newest partner at Dechert working on fund formation, agrees the story of 2008 will indeed focus on the middle market and that there will plenty of good funds raised this year. “There’s work to be done in the middle market. Less mega $15 billion funds will be raised, but the smaller ones will be successful at getting allocated.”

In fact, some argue, larger funds would be foolish to raise vehicles now as it would be virtually impossible to put the capital to work in a suitable timeframe, which could put LPs in the uncomfortable position of demanding capital to be returned.

“LPs will cut back their commitment if the firms can’t put the money to work,” Scanlan says, “No one is going to pay a management fee if the money is not being put to work, and the private equity firms wouldn’t give it back voluntarily.”

However, of the pension funds Scanlan works with, most still have an appetite for the asset class — just middle-market private equity. “The long-term story is good, there’s still business to be done in the middle market,” he says.

Indeed, according to a recent survey by Probitas Partners, among North American investors, 57% felt U.S. middle-market vehicles would yield the best returns from 2008 vintage funds. That was followed by European middle-market funds with 41.7% of respondents saying they would produce the highest returns. Coming in third, with 31.8% of the vote, was U.S. venture capital vehicles.

Mega-buyout funds, those larger than $5 billion, came in fifth with 7.9% predicting those funds would be top performers. (Respondents were able to choose more than one answer, accounting for numbers adding up to more than 100%.) While these are just predictions, it would seem that the famous barbell theory — targeting both large-market and small-market investors, while avoiding everything in between — might have run its course.

“The world of mega funds, which relies on large amounts of syndication, will face headwinds. Folks who are less dependent on leverage will have an easier time,” says one LP, who has invested in a number of mid-market funds lately. “Financial engineering doesn’t really distinguish anyone anymore; you have to have a niche. It’s hard to convince an LP you will produce good returns if there isn’t a portion of the world you know better than others.”

There are plenty of firms, big and small, raising capital and closing on funds. However, each does seem to have a niche. For starters, Advent International has closed its sixth global buyout fund with about $10.4 billion in commitments. Media-focused ABRY Partners has raised $1.35 billion for its sixth fund, which is expecting to close with $3 billion. Alinda, a new firm investing in infrastructure deals, is in the midst of raising its second fund. Its target is $3 billion.

Meanwhile, Lincolnshire is gearing up to raise its fourth fund, hoping to garner $700 million. Blue Wolf Capital Management is working on raising its second fund, while Black Eagle Partners, a distressed investor, is close to finalizing its first fund with between $200 million and $250 million. Others, such as CIVC Partners, are also undaunted by the current market. CIVC hired UBS as a placement agent to market a new vehicle, expected to target around $650 million.

To be sure, headwinds do face those raising funds in 2008. LP commitments, for instance, could shrink if weakness in the stock market puts LPs past their allocation for alternative assets. With that said, if GPs can distinguish themselves, they should be able to rouse interest.

“LPs are looking for funds that can differentiate themselves. If you look at the funds in the market today they all have something a little different, whether it’s a sector focus or regional focus, there really aren’t generalist funds out there raising capital,” says one general partner in the midst of raising a fund. “As private equity becomes more and more sophisticated there are declining margins and more competition. It’s going to be really hard for any generalist funds to raise capital.”