The transformation comes with challenges. Three of the five biggest leveraged-buyout, or LBO, companies have sold shares to the public to finance entry into ventures where they face stiff competition and sometimes earn lower fees.

“It's not hard to start or buy other businesses,” Blackstone President Tony James said in an interview. “What's hard is creating businesses that are best at what they do.”

Aging Founders
Fund managers are stepping up efforts to diversify, a trend that began in the 1990s as a way to smooth the boom-and-bust cycle of LBOs. That makes their firms more attractive to public investors, who must overcome doubts about whether they should buy stock from people who built their fortunes picking the right moment to sell. For aging founders, now in their 60s, a public listing creates liquidity for their ownership stakes.

Blackstone was one of the first to go public, in June 2007, when earnings from real estate and buyouts were about equal. This year, property deals propelled quarterly economic net income, a measure of profit, to a record, rising fourfold to $361 million in the first three months, while private equity fell 9 percent to $175.5 million.

Property Deals
The New York-based company's largest investment in the last 12 months was the $9.4 billion deal to buy 593 U.S. shopping centers from Australia's Centro Properties Group. It would be the largest cash purchase of real estate in the world since the collapse of Lehman Brothers Holdings Inc. in 2008, Schwarzman, 64, told investors in an April conference call.

Blackstone has three investment businesses “equal to or greater in scale” than private equity, James said.

At Carlyle Group, ranked second by assets under management, co-founder David Rubenstein has steered the Washington-based firm into the fund-of-funds business by taking over AlpInvest, a Dutch asset manager that spreads money for investors among other buyout funds. Rubenstein, 61, also agreed buy a majority stake in Claren Road Asset Management LLC, a hedge fund that trades debt, and is considering taking the company public.

KKR, created in 1976 by Kravis, Roberts and Jerome Kohlberg, is best known for staging what at the time was the largest LBO in history, the $30 billion takeover of RJR Nabisco Inc. in April 1989. It has ventured into underwriting stock and bond offerings, investing in infrastructure deals and, most recently, operating hedge funds. Like their peers, KKR's founders are reducing dependence on the deals that vaulted them into the ranks of the world's richest men and formed the cornerstone of what is today a $2.5 trillion industry.

KKR Returns
Investors in KKR's 1986 fund got more than 13 times their money back, a performance the firm hasn't been able to repeat, according to its annual report.

Buyout funds use a mix of cash and debt to buy companies and typically try to improve operations before selling within about five years. To pay the debt, the new owners often slash costs by cutting jobs, closing factories and selling assets.

The LBO business has become more crowded, with almost eight times as many firms last year as the 60 active in 1990. Cheap debt has fueled competition and driven up bids, making it harder for managers like Leon Black's Apollo Global Management LLC to find suitable targets, President Marc Spilker told investors last month. Raising funds has also become harder.

'Not Fun'
“As the business exploded, more and more people rushed into private equity, which made competition for money fierce,” said Richard Beattie, chairman of New York-based law firm Simpson Thacher & Bartlett LLP, who helped KKR engineer the RJR Nabisco takeover and remains an adviser to many private-equity firms. “As a result, the founders spent more time fundraising, which is not fun. Going to the public markets for permanent capital is a solution.”

Diversification makes sense for private-equity managers seeking more revenue, diminished risk and a less cyclical business than a pure buyout firm, said Anthony Tutrone, head of the alternatives unit at New York-based Neuberger Berman Group LLC. It's not clear how investors in private-equity funds benefit, he said.

“With a large fee base, the manager wins regardless of performance,” Tutrone said. “Investors want to avoid situations where managers stop questioning whether they win and instead are just asking by how much.” The firms say investors' interests are aligned with those of the founders, who have their own money in the funds. Carlyle partners, management teams and employees have committed or invested more than $4 billion of after-tax dollars alongside Carlyle's funds, according to the company's annual report.

Lower Fees
Some wins from diversification come with smaller profit margins. Buyout firms typically collect a 1.5 percent to 2 percent fee on assets under management and a 20 percent cut of any profit. While the new businesses may produce comparable management fees, they can offer little or no incentive fees.

One Blackstone fund specializing in commercial loans and junk-rated debt charges an average 1.2 percent annual management fee and gets no incentives for good performance. Carlyle's AlpInvest, which has more than $57 billion in assets under management according to its website, generated about $86 million in 2009 revenue, which included management and incentive fees.

Blue Wave
The new ventures face established rivals in asset management and real estate and aren't always profitable.

Carlyle Blue Wave Partners, the firm's first attempt at a hedge fund in 2007, saw assets drop by a third to $600 million by 2008 as the market for mortgage securities froze. Carlyle Capital Corp., a mortgage-bond fund, missed more than $400 million of margin calls and was suspended from public trading in 2007 after less than two years. Apollo's real estate unit posted a first-quarter loss the company said was tied to the purchase of Citi Property Investors from Citigroup Inc. in November.

Competitors include BlackRock Inc., the world's largest money manager with $3.6 trillion of assets under management, whose initial backers included Blackstone. BlackRock is also expanding its private-equity and real estate offerings and has $115 billion invested in such so-called alternative products, Chief Executive Officer Larry Fink told investors last month.

For property investments, buyout funds must bid against publicly traded real estate investment trusts such as Mortimer Zuckerman's Boston Properties Inc., with $13.8 billion in assets and a 10-year total return of 352 percent, counting the share- price increase and dividends.

'Pricing Power'
“There haven't been many investment strategies that have survived unscathed,” said Mitch Petrick, Carlyle's managing director, who is charged with moving the firm into hedge-fund strategies with the potential for more lucrative returns. “After the turmoil, many investors asked themselves whether they should've been paying 2 and 20 for some strategies.”

Petrick, a Morgan Stanley veteran hired by Rubenstein last year, led the Claren Road acquisition. Similar deals are on the way, he said in an interview. Petrick said he also may hire new teams of traders whose performance can justify higher fees.

“If you have a unique product, you'll have pricing power,” he said.

The firm has rebranded Petrick's unit Global Market Strategies, removing the word “credit” from its name, to mark a shift away from a business concentrated on low-risk, long-term loans to one whose investments fluctuate in value daily. One strategy is a long-short hedge fund that trades stocks and another seeks to capitalize on trends in emerging markets.

“We're building new products and adding new geographies and people to give our clients more choice and asset- diversification options,” Rubenstein said in an interview.

Blackstone's GSO
That might appeal to James Dunn, chief investment officer at Wake Forest University in Winston-Salem, North Carolina, who said he's paring the number of his endowment fund's general partner relationships by more than a third, to 29 from 44.

“If you only do one thing really well, I can't deal with you,” Dunn said May 4 during a panel discussion at the Milken Institute Global Conference in Beverly Hills, California.

Among Blackstone's fastest-growing businesses is its credit division, comprised mostly of activities tied to its GSO funds. The unit uses hedge funds, loans to troubled companies and mezzanine lending for investment ideas distinct from traditional corporate takeovers, often involving targets too small to attract the firm's private-equity dealmakers. The name comes from founders Bennett Goodman, Tripp Smith and Douglas Ostrover, who worked with James at Donaldson Lufkin & Jenrette and sold their business to Blackstone in 2008.

Falling Profit
The operation now ranks fourth in terms of profitability at the company, with a margin of 39 percent compared with private equity's 64 percent during the first quarter. The business produced $60.5 million in economic net income last quarter, about one-third of the $175.5 million for private equity.

Blackstone's credit and marketable alternative business, which comprised its fund-of-funds unit as well as GSO, increased economic net income 40 percent in 2010 to $372 million from the previous year. Private-equity profit fell by about 1 percent to $485 million over the same period. Blackstone started reporting GSO and the fund of funds separately last quarter.

KKR has been slower to diversify. The business that houses its main non-LBO operations reported economic net income of $15.9 million in the first quarter compared with the private- equity unit, which cleared $276.7 million in the period.

'Core and Heritage'
KKR Asset Management has expanded into mezzanine lending and so-called special situations in which the firm uses debt to rescue or expand companies. Through that business, headed by William Sonneborn, 41, formerly the president of money manager TCW Group Inc., KKR is also getting into hedge funds. The firm hired a group of former Goldman Sachs Group Inc. traders led by Bob Howard to pursue a long-short equities strategy that allows managers to bet on rising and falling stocks.

In real estate, KKR hired former Goldman Sachs executive Ralph Rosenberg to oversee investments. Initially, KKR won't raise a discrete real estate fund, instead opting to tap existing equity and debt funds for property deals, Scott Nuttall, head of global capital at KKR, said on a May 4 conference call.

“Private equity is our core and heritage, and it's still the biggest business, and we expect it to be going forward,” Nuttall said in an interview. “It may take us longer, but our expansion will be quite sustainable.”

Oregon Fund
The search for new revenue reflects the limits of leveraged buyouts as targets become more expensive and clients balk at committing new funds. The first three months of 2011 represents the fifth straight quarter without a fund closing on more than $5 billion, according to Pitchbook, a private-equity deal database.

Oregon Public Employees Retirement Fund, one of KKR's original investors, committed $500 million to the firm's latest pool, one-third the $1.5 billion it invested in a predecessor in 2006. The pension fund is “scaling back” its commitments to other private-equity companies as well in an effort reach target levels, Chief Investment Officer Ron Schmitz said in an e-mail.

For years, buyout firms didn't need much of a sales force because the founders acted as rainmakers. Now, New York-based Apollo is stepping up spending on a marketing team to round up new cash, Chief Financial Officer Eugene Donnelly said on a May 12 conference call.

When the firms do get new money, they're finding fewer opportunities to deploy it. Blackstone, which is raising a $15 billion fund, committed only $550 million in private equity during the first quarter, Schwarzman told investors in April.

'Diminished' Expectations
“The top managers aren't moving away from LBOs,” said Ros Stephenson, co-head of corporate finance at Barclays Capital in New York. “The importance of their other businesses has been emphasized given what's happened. Expectations on fund sizes have diminished, and average LBO deals are smaller than pre- crisis. There isn't the capacity to support deals of $20 billion plus at the moment.”

Private-equity managers are trying to boost returns by going where rivals can't because they lack the firepower, or by taking advantage of distressed sellers.

“In virtually all recent transactions, Blackstone has faced limited competition due to the magnitude of capital required and the complexity of the transactions,” Schwarzman said during the April conference call.

Apollo raised $565 million in a March public offering. That amount included 21.5 million shares sold by the firm, as well as 8.26 million by stockholders such as Goldman Sachs.

Apollo has been scouring European banks for “stranded assets,” including $2 billion of non-performing commercial loans, Spilker told investors on May 12. Another $240 million is earmarked for “longevity-based assets,” a bet on the value of life insurance policies Apollo is buying from banks.

Exit Plan
The firm began diversifying in 2003 with the creation of a capital-markets business that invests in high-yield bonds and loans. The division, which had $23.8 billion under management as of the end of the first quarter, now accounts for 34 percent of Apollo's total.

Selling stock to the public provides managers with a way of cashing out and passing the company on to the next generation. Some firms, such as New York-based Warburg Pincus LLC, shifted ownership and control without a public listing. The drawback is that executives who use this method wouldn't get compensated for the intangible value of the brand they created.

“Our founders had a very old-school way of thinking,” said Joseph Landy, 49, co-president of Warburg Pincus, which has raised $30 billion in private-equity funds since 1971.

Public Investors
Results for shareholders of private-equity companies have been mixed. KKR gained 63 percent through last week since it shifted its listing to New York last year from Amsterdam, where its publicly traded European entity had lost more than half its value since 2006. While Blackstone gained 55 percent in the past 12 months through last week, its shares were still 45 percent below the IPO price. Apollo, which this year moved its listing to the New York Stock Exchange from a private exchange run by Goldman Sachs, was down 4.3 percent since March.

Still, most Wall Street analysts favored the companies, with a cumulative tally of 26 “buy” recommendations, 6 “holds” and no “sell” recommendations.

Private-equity executives will have to persuade public investors that a more stable stream of earnings with lower margins is worth a higher multiple. Their track record of buying low and selling high makes investors such as Harold Bradley skeptical.

“When the smart money is selling, I'm not convinced investors should be paying up,” said Bradley, chief investment officer of the Ewing Marion Kauffman Foundation in Kansas City, Missouri, which promotes entrepreneurship. “In the late 1990s, all the boutique investment banks sold, knowing it was a bubble. Now the private-equity firms that couldn't get public during the peak are trying.”

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