After making their founders billionaires, buyout specialistssuch as Carlyle Group and KKR & Co. are turning into assetmanagers that run hedge funds and strip malls as fresh capital andtakeover targets become scarce.

Stephen Schwarzman's Blackstone Group LP, the biggestprivate-equity firm, is earning twice as much from owning property,including office buildings in India and senior communities, as frombuyouts. New York-based KKR, whose co- founders Henry R. Kravis andGeorge R. Roberts helped pioneer leveraged buyouts in the 1980s,now owns a stake in a 5,500-mile U.S. pipeline and lends todistressed companies.

The firms have little choice if they want to grow. Takeovercandidates are expensive after a two-year, 95 percent rally instocks, and commitments from backers such as pension funds havewaned amid the weakest fundraising environment since 2003.

“The large-cap leveraged buyout business has become mature,”said Colin Blaydon, director of the Center for Private Equity andEntrepreneurship at Dartmouth College's Tuck School of Business inHanover, New Hampshire. In the future, private- equity firms willlook “more like the large money-management enterprises, with a bigemphasis on assets under management.”

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

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

Aging Founders
Fund managers are steppingup efforts to diversify, a trend that began in the 1990s as a wayto smooth the boom-and-bust cycle of LBOs. That makes their firmsmore attractive to public investors, who must overcome doubts aboutwhether they should buy stock from people who built their fortunespicking the right moment to sell. For aging founders, now in their60s, a public listing creates liquidity for their ownershipstakes.

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

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

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

At Carlyle Group, ranked second by assets under management,co-founder David Rubenstein has steered the Washington-based firminto the fund-of-funds business by taking over AlpInvest, a Dutchasset manager that spreads money for investors among other buyoutfunds. Rubenstein, 61, also agreed buy a majority stake in ClarenRoad Asset Management LLC, a hedge fund that trades debt, and isconsidering taking the company public.

KKR, created in 1976 by Kravis, Roberts and Jerome Kohlberg, isbest known for staging what at the time was the largest LBO inhistory, the $30 billion takeover of RJR Nabisco Inc. in April1989. It has ventured into underwriting stock and bond offerings,investing in infrastructure deals and, most recently, operatinghedge funds. Like their peers, KKR's founders are reducingdependence on the deals that vaulted them into the ranks of theworld's richest men and formed the cornerstone of what is today a$2.5 trillion industry.

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

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

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

'Not Fun'
“As the business exploded, moreand more people rushed into private equity, which made competitionfor money fierce,” said Richard Beattie, chairman of New York-basedlaw firm Simpson Thacher & Bartlett LLP, who helped KKRengineer the RJR Nabisco takeover and remains an adviser to manyprivate-equity firms. “As a result, the founders spent more timefundraising, which is not fun. Going to the public markets forpermanent capital is a solution.”

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

“With a large fee base, the manager wins regardless ofperformance,” Tutrone said. “Investors want to avoid situationswhere managers stop questioning whether they win and instead arejust asking by how much.” The firms say investors' interests arealigned with those of the founders, who have their own money in thefunds. Carlyle partners, management teams and employees havecommitted or invested more than $4 billion of after-tax dollarsalongside Carlyle's funds, according to the company's annualreport.

Lower Fees
Some wins from diversificationcome with smaller profit margins. Buyout firms typically collect a1.5 percent to 2 percent fee on assets under management and a 20percent cut of any profit. While the new businesses may producecomparable management fees, they can offer little or no incentivefees.

One Blackstone fund specializing in commercial loans andjunk-rated debt charges an average 1.2 percent annual managementfee and gets no incentives for good performance. Carlyle'sAlpInvest, which has more than $57 billion in assets undermanagement according to its website, generated about $86 million in2009 revenue, which included management and incentive fees.

Blue Wave
The new ventures faceestablished rivals in asset management and real estate and aren'talways profitable.

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

Competitors include BlackRock Inc., the world's largest moneymanager with $3.6 trillion of assets under management, whoseinitial backers included Blackstone. BlackRock is also expandingits private-equity and real estate offerings and has $115 billioninvested in such so-called alternative products, Chief ExecutiveOfficer Larry Fink told investors last month.

For property investments, buyout funds must bid against publiclytraded real estate investment trusts such as Mortimer Zuckerman'sBoston Properties Inc., with $13.8 billion in assets and a 10-yeartotal return of 352 percent, counting the share- price increase anddividends.

'Pricing Power'
“There haven't been manyinvestment strategies that have survived unscathed,” said MitchPetrick, Carlyle's managing director, who is charged with movingthe firm into hedge-fund strategies with the potential for morelucrative returns. “After the turmoil, many investors askedthemselves whether they should've been paying 2 and 20 for somestrategies.”

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

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

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

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

Blackstone's GSO
That might appeal toJames Dunn, chief investment officer at Wake Forest University inWinston-Salem, North Carolina, who said he's paring the number ofhis endowment fund's general partner relationships by more than athird, 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 InstituteGlobal Conference in Beverly Hills, California.

Among Blackstone's fastest-growing businesses is its creditdivision, comprised mostly of activities tied to its GSO funds. Theunit uses hedge funds, loans to troubled companies and mezzaninelending for investment ideas distinct from traditional corporatetakeovers, often involving targets too small to attract the firm'sprivate-equity dealmakers. The name comes from founders BennettGoodman, Tripp Smith and Douglas Ostrover, who worked with James atDonaldson Lufkin & Jenrette and sold their business toBlackstone in 2008.

Falling Profit
The operation now ranksfourth in terms of profitability at the company, with a margin of39 percent compared with private equity's 64 percent during thefirst quarter. The business produced $60.5 million in economic netincome last quarter, about one-third of the $175.5 million forprivate equity.

Blackstone's credit and marketable alternative business, whichcomprised its fund-of-funds unit as well as GSO, increased economicnet income 40 percent in 2010 to $372 million from the previousyear. Private-equity profit fell by about 1 percent to $485 millionover the same period. Blackstone started reporting GSO and the fundof funds separately last quarter.

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

'Core and Heritage'
KKR Asset Managementhas expanded into mezzanine lending and so-called specialsituations in which the firm uses debt to rescue or expandcompanies. Through that business, headed by William Sonneborn, 41,formerly the president of money manager TCW Group Inc., KKR is alsogetting into hedge funds. The firm hired a group of former GoldmanSachs Group Inc. traders led by Bob Howard to pursue a long-shortequities strategy that allows managers to bet on rising and fallingstocks.

In real estate, KKR hired former Goldman Sachs executive RalphRosenberg to oversee investments. Initially, KKR won't raise adiscrete real estate fund, instead opting to tap existing equityand debt funds for property deals, Scott Nuttall, head of globalcapital at KKR, said on a May 4 conference call.

“Private equity is our core and heritage, and it's still thebiggest business, and we expect it to be going forward,” Nuttallsaid in an interview. “It may take us longer, but our expansionwill be quite sustainable.”

Oregon Fund
The search for new revenuereflects the limits of leveraged buyouts as targets become moreexpensive and clients balk at committing new funds. The first threemonths of 2011 represents the fifth straight quarter without a fundclosing on more than $5 billion, according to Pitchbook, aprivate-equity deal database.

Oregon Public Employees Retirement Fund, one of KKR's originalinvestors, 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 otherprivate-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 forcebecause the founders acted as rainmakers. Now, New York-basedApollo is stepping up spending on a marketing team to round up newcash, Chief Financial Officer Eugene Donnelly said on a May 12conference call.

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

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

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

“In virtually all recent transactions, Blackstone has facedlimited competition due to the magnitude of capital required andthe complexity of the transactions,” Schwarzman said during theApril conference call.

Apollo raised $565 million in a March public offering. Thatamount included 21.5 million shares sold by the firm, as well as8.26 million by stockholders such as Goldman Sachs.

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

Exit Plan
The firm began diversifying in2003 with the creation of a capital-markets business that investsin high-yield bonds and loans. The division, which had $23.8billion under management as of the end of the first quarter, nowaccounts for 34 percent of Apollo's total.

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

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

Public Investors
Results for shareholdersof private-equity companies have been mixed. KKR gained 63 percentthrough last week since it shifted its listing to New York lastyear from Amsterdam, where its publicly traded European entity hadlost more than half its value since 2006. While Blackstone gained55 percent in the past 12 months through last week, its shares werestill 45 percent below the IPO price. Apollo, which this year movedits listing to the New York Stock Exchange from a private exchangerun by Goldman Sachs, was down 4.3 percent since March.

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

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

“When the smart money is selling, I'm not convinced investorsshould be paying up,” said Bradley, chief investment officer of theEwing Marion Kauffman Foundation in Kansas City, Missouri, whichpromotes entrepreneurship. “In the late 1990s, all the boutiqueinvestment banks sold, knowing it was a bubble. Now theprivate-equity firms that couldn't get public during the peak aretrying.”

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