The Bulge Bracket is Coming for the Middle Market

Bulge bracket banks have been circling the middle and lower middle M&A markets for quite some time now. The events of the last few months have finally forced some storied institutions to make their moves down market in search of increasingly scarce value in a pandemic-stricken economy. 

Time to sound the alarm? 

Probably not. Concerns of disruption and increased competition are certainly not unfounded, but this shifting market participation is most likely a temporary response to unprecedented circumstances related to COVID-19. Competitive challenges and simple economics represent major hurdles that should encourage the largest banks to revert back to normal operations in short order.

Coronavirus is Pulling Large Banks Deeper into the Middle Market

M&A activity is down 25% year-over-year through the first three quarters of 2020, but the middle market has fallen a mere 14%. Smaller acquisitions are less likely abandoned or delayed amid uncertainty relative to riskier major transactions. Further, the middle market appears to be fueled by exposure to a more active healthcare sector, as well as motivated private sellers who are anxious to close before a second nation-wide economic shutdown.

With revenue drying up, the largest banks are ramping participation in deals valued below $500 million. These banks have typically avoided this market because the revenue was simply too small to warrant resources and attention. However, lean times encourage adaptation. Bank of America, Citigroup, Goldman Sachs, JPMorgan, and Morgan Stanley combined for 9.2% of the smaller deal advisory market in the first 9 months of the year. That’s a fairly small slice, but it is 220 basis points higher than two years ago, and the largest share since 2015.

Goldman, specifically, has been making explicit efforts to expand its presence in the segment for several years. In addition to IB and advisory, the firm has moved aggressively into commercial lending for the LMM, where volume has increased 37% annually since 2010. Downstream revenues have clearly been targeted strategically.

Temporary Diversion or Acceleration of Trend?

It remains to be seen if this is a cyclical and opportunistic reaction to extreme circumstances, or if this actually signals a new reality in which LMM incumbents will experience heightened competition from larger organizations. In the latter, it would certainly create a shakeup in personnel, fees, new business development, and potentially client engagement processes. That would echo trends unfolding in other industries, where systemic evolutions are accelerating and the best-equipped players are consolidating market share.

While there are undeniable signs that some long-term changes have taken root, the landscape will most likely revert to prior conditions as the global economy normalizes. It simply doesn’t make sense for the largest banks to continue dedicating major resources to opportunities with unfavorable economics where they may face competitive disadvantages.

When larger-scale M&A activity resumes (or perhaps even accelerates due to pent-up demand and the renewal of previously shelved deals), the big IBs will be eager to chase those proportionately large fees. Bigger organizations have corresponding expense structures to support, and the return profile from the LMM is simply less likely to catalyze participation. It won’t make sense for them to eschew more lucrative opportunities in favor of a less familiar and more fragmented market segment.

The challenges faced by large banks wading deeper into the LMM shouldn’t be understated, either. These are larger, more bureaucratic entities with limited experience in smaller deals and relatively inflexible processes. Middle market specialists have developed trust and reputation with a track record of value creation, and they maintain nimble organizations that can move more quickly as smaller deals often demand. This is not lost on the owners and executives at target firms, who would certainly be skeptical about the expertise of any assigned personnel and overall dedication from larger banks courting their business.

2021 could see above-average participation from big banks in the middle market, but it seems far less likely that their market share will continue to rise. It stands to reason that unprecedented circumstances have forced some adjusted behavior and conjured some survival instincts. Large banks would need to overcome simple economics and competitive disadvantages to further expand their footprint in the LMM, so we suspect that reversion to previous conditions is the probable outcome.