Is the party over? That’s what anxious investors want to know.

To some observers, last week’s sell-off adequately discounted a retrenchment in takeover activity, which will likely last only a few months. This optimistic appraisal is based on:

• The amount of money that private equity firms have amassed, and that ultimately will have to be invested.

• The banking sector is in very good shape and will be able to handle some losses on bridge loans — that is, we are not looking at a financial crisis.

• Opportunistic hedge funds will likely move in to buy up loans currently being dumped at sizeable discounts.

• Strategic buyers have been shut out of the takeover market by rising prices and may now become more aggressive.

• The economy is still in reasonable shape and the stock market is not selling at exorbitant prices.

Still, last week was no fun. After several years of feverish takeover activity fueled by easy money, credit markets suddenly seized up like a rusty engine. Conversations with players in the private equity business during the day on Friday were progressively downbeat as ever more alarming stories were handed around.

Banks holding sizeable bridge loans were suddenly stuck and responded by dumping paper on a jittery market. One private equity honcho, who did not want to be quoted, reported that Home Depot debt, for instance, was rumored to be trading at 80 cents on the dollar. In a later e-mail message, he reported: “The leveraged loan market is effectively closed. Anything requiring syndication and not under an existing commitment letter is on hold for a while.” Another source said that bank loans were being priced at fouryear lows, and that some banks were trying to sell multibillion-dollar portfolios.

What does this mean in terms of deal flow? The head of the private equity firm Diamond Castle, Larry Schloss, summed up the situation this way: “Consider three different situations. In the first case, a company is in the process of being sold, but the buyer has lined up only bridge financing. The banks that have made those loans normally syndicate them as soon as possible. Right now the banks aren’t able to sell those loans, so they probably will be reluctant to make any new ones. In this case, the buyer will not walk away from the transaction, the deal will close, but the buyer is looking at somewhat lower returns.

“In the second case, the buyer has not lined up any financing, and all of a sudden the market won’t extend as much credit as was available a week ago. So maybe instead of using leverage of seven or eight times equity, the buyer can only borrow five or six times his equity stake. He’ll probably go ahead with the deal, but returns are going to be lower.

“In the third case, a company CEO is thinking of selling his company. Now his banker is telling him to wait until things settle down.”

The bottom line? New buyouts are on hold and takeovers just got a lot more expensive. Without a doubt, record-setting private equity returns are headed lower.

More important to the stock market, the credit markets have come in for some serious adjustment, which many observers thought was long overdue. Risk spreads, which have been at historic lows, have widened. Specifically, International Strategy & Investments reported that by Thursday, high-yield spreads had climbed to 361 basis points, an increase of about one-third from six months ago.

How long will the hiatus last? Martin Fridson, author of Leverage World, a weekly trade publication on the high-yield markets, says no one knows for certain. “Certainly not before Labor Day, and there’s no guarantee it will comebackafterLaborDay. There’s a lot to work through, including the unwinding of CLO warehouses. It’s clear though that the terms offered to private equity players of late won’t be seen again for a long time.”

Meanwhile, the 4.2% drop in the Dow Jones index seems a reasonable downgrade for reduced takeover prospects, especially because the sell-off focused heavily on companies thought to be in play. There may be some further downgrading of the financial sector as the impaired outlook for buyouts filters through to earnings estimates for investment banks.

For the balance of the market, the outlook for profits and of the economy should be paramount. Recent news on this front has been mixed, but not altogether negative. Second-quarter growth was boosted by a surge in business spending, which has been some time in coming and which bodes well for continued productivity gains. This is important because in recent years, price increases have been minimal, meaning that corporate profit growth has stemmed heavily from productivity increases.

At the same time, falling home prices and high gasoline prices have finally taken a toll on consumer spending. The folks at ISI are estimating that employment in July rose by 160,000 (versus the consensus of 125,000), but also that hiring of temporary workers — a good leading indicator of payroll — is softening.

Market experts are also not convinced that the Federal Reserve will cut rates later this year, despite strong sentiment to that effect in Friday’s futures markets. If they are correct, the market may trade in a fairly narrow range in the near term. This may be one of those times when investors have to become more discerning and seek out companies that really are growing and that offer particularly good value. In other words, making money the old-fashioned way.

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