by James Politi and David Wells

Reprinted with special permission of the Financial Times

Arnold Schwarzenegger, governor of California and Hollywood film star, loves Humvees, the wide-bodied military vehicles made famous in the Gulf war. But he does not love them as much as Jimmy Elliot, head of JP Morgan Chase's North American mergers and acquisitions business.

Earlier this month, Mr. Elliot's bankers helped two private equity specialists on the sale of AM General, the Humvees' manufacturer, and, with General Motors, the builder of the smaller Hummer H2 - the commercial version favoured by hip-hop impresarios such as Wyclef Jean, whose own car sports a shark tank.

Renco Group, JP Morgan Chase's client, and MacAndrews and Forbes formed a joint venture that values AM General at $935 million. That is a pittance compared with the takeover by Sanofi-Synthelabo, the French pharmaceutical giant, of Aventis, which cost $70.7 billion. But these days Wall Street's fancies are as often taken by smaller transactions - known in the jargon as "middle-market" deals - as by multi-billion dollar assignments.

Investment bankers lust for the bragging rights of a big deal. But their wallets are not so large that they cannot find room for a smaller transaction. Merrill Lynch, JP Morgan Chase, Citigroup, Credit Suisse First Boston and others are all investing heavily in efforts to target mid-sized businesses - hiring extra staff or reorganising their operations.

The reason is simple: in a world where several banks share the credit for large deals, who would not love a $5 million fee for being the sole adviser on a $400 million transaction, especially when there are scores of such opportunities? Wall Street has long known that, in any normal year, about half of the fees generated by investment bankers come from the shallow end. But during the abnormal bull market years of the late 1990s, when megamergers and initial public offerings were two-a-penny, the largest investment banks shed their ties with smaller US companies.

Times have changed, however. These days, the majority of fees are coming from smaller transactions. In 2003, 61 percent, or $5.6 billion of all advisory fees for mergers and acquisitions around the world came from deals worth $1 billion or less, according to Dealogic, a UK-established company which tracks such figures.

That was a record, and it caught the attention of many key bankers. As Mr. Elliot says: "Transactions between $200 million and $1 billion are the most profitable from a margin point of view. "This is because you potentially have the opportunity to be sole adviser and you will be dealing in situations where incentive fees will allow you to make more money than otherwise." Although Dealogic's analysis excludes transactions with undisclosed sums, bankers across Wall Street see the number as significant when compared with figures from the previous five years, when the proportion of small deals compared with overall merger and acquisition volumes ranged from 45 percent to 54 percent.As well as the opportunity for exclusivity on a small deal, there are several other reasons for the surge in interest from Wall Street's bankers. One is that the three-year bear market in equities meant deal sizes often drifted down into the middle market category. Also, investment bankers had to expand their client base because large companies, threatened by Sarbanes-Oxley and other issues, were refraining from making purchases and raising money. Another factor has been the recent frenzy of buying and selling of assets by US private equity houses.

According to M&A market analysis - compiled by Robert W. Baird, a Milwaukee-based investment bank - the volume of middle market deals involving these specialist financiers has more than doubled from $30 billion in the first half of 2003 to $63.5 billion in the first half of this year. Whether the trend of big investment banks courting small companies continues is anybody's guess. Wall Street tends to be fickle about wooing small companies, which often have better relationships with smaller banks - such as Wachovia or Wells Fargo - or boutique investment banks founded by castaways from the New York giants.

Many small businesses bristle at the idea of a leading investment bank showing up on the doorstep, cap in hand. But several, impressed by the attention of powerful banks, are giving them a chance. And even though the US economy has tepid signs of recovery and larger mergers have splashed across the front pages of newspapers this year, Wall Street has not given any outward indication that it is about to abandon its new strategy to pursue middle market business.

Over the past year, Merrill Lynch has made an effort to build on the strong relationships it has with small companies through its brokerage and commercial lending businesses. It wants to leverage its well-known brand with smaller businesses around the world.

While Merrill Lynch has been an adviser on seven of the year's 10 largest announced transactions including Sanofi-Aventis, Greg Fleming, Merrill's co-head of global investment banking, says he needs smaller clients to diversify his revenue sources and sustain his department when the larger deals disappear. Besides, he says, the small companies often grow into Fortune 100 or 500 companies.

"In every major developed economy - including the US, Germany and Japan - there is a significant number of middle market companies," says Mr. Fleming. "We think it's an attractive segment in and of itself and also a feeder for large companies later." But even while they are still small growing companies, they need a fair amount of financing, whether high-yield debt, structured products, or even an IPO, says Mr. Fleming. They also need help with mergers and acquisitions.

The reason that investment banks are likely to remain committed to the middle market sector is that they have a better shot at being a client's sole adviser - which carries the greatest remuneration.

With large deals, there are so many others involved in the process. Take Sanofi-Aventis. Seven banks acted as advisers on the transaction and there were lawyers as well. In addition, while bankers are more tempted to cut fees on large deals to earn league table credit - a ranking system that is a key marketing tool for Wall Street - there are fewer reasons to do so on small deals.

But bankers are loath to say that the middle market is a less competitive environment. Marc Granetz, global head of Credit Suisse First Boston's M&A business - which has been the top global fee earner for deals smaller than $1 billion since January 2003, according to Dealogic - says: "Along with the large investment banks, regional banks and boutiques are competing in the same space. Also, clients are no less demanding than in large transactions: they care a lot about these deals. Often management has a lot invested in the company." Moreover, the private equity houses do not necessarily fit the traditional model of relatively un-savvy consumers of banking services that have been such a fertile ground for investment bankers hungry for more fees.

"Private equity groups are very sophisticated consumers of investment banking services and they don't tend to pay especially lucrative advisory fees if we are providing financing," says Mr. Granetz. Not all the Wall Street banks are enthusiastic about the middle market sector. Morgan Stanley, for instance, has resisted the temptation to establish a broad middle market capability, preferring instead to pursue small companies in selective high-growth sectors such as bio-technology.

But the enthusiasts are - in spite of the skeptics and the sophisticated clientele - busily building their business. Citigroup, which is vigorously expanding its efforts to work with smaller companies, admits that the strategy works best when helping the seller rather than the buyer. Frank Yeary, co-head of global mergers and acquisitions at Citigroup, says: "The middle market offers a great opportunity, especially for sell-sides, where we often find clients receptive to incentive fee arrangements.

"Meanwhile, financial services companies with links to smaller businesses, such as lending arrangements or brokerage accounts, are looking to find creative new ways to tap those contracts for more business.

Merrill's Mr. Fleming is tapping into relationships developed by the company's army of brokers and Merrill Lynch Capital Partners, a lending arm: "They have relationships with CEOs and chief financial officers which they have developed in their community, are often helpful in introducing people, and are one of the reasons we can differentiate ourselves." With this leg-up, Mr. Fleming is targeting companies that raise money by selling high-yield debt. His goal is to push Merrill up the league tables.

Likewise, JP Morgan Chase, which also has strong ties with smaller companies because it lends them money, is focusing on the middle market business - and with some success. On the same day that the AM General transaction was announced it also advised Paint Sundry Brands, a manufacturer of paint brushes and rollers that is in the portfolio of Lindsay Goldberg & Bessemer, a private equity firm.

Sherwin-Williams, a paint-maker, agreed to pay $300 million for Paint Sundry. The bank won the business in part because of a long-standing lending relationship.

For JP Morgan and others, using their other businesses will be one way of differentiating themselves. In a market that is quickly getting crowded, this will be critical if they want to sign another Humvee-style humdinger of a deal.

(c) The Financial Times