Buyout Firms Seek New Horizons

Stephen A. Schwarzman, David M. Rubenstein, Henry R. Kravis, and George R. Roberts became billionaires by engineering leveraged buyouts. Now they're transforming their companies into asset managers that run everything from hedge funds to strip malls as fresh capital and takeover targets become scarce.

Schwarzman's Blackstone Group (BX), the biggest private equity firm, is earning twice as much from owning property, including office buildings in India and seniors communities in Oregon, as from buyouts. Kravis and Roberts's KKR (KKR) owns a stake in a 5,500-mile U.S. fuel pipeline and lends to distressed companies. "The large-cap leveraged buyout business has become mature," says Colin C. Blaydon, director of the Center for Private Equity & Entrepreneurship at Dartmouth College's Tuck School of Business. In the future, private equity firms will look "more like the large money-management enterprises, with a big emphasis on assets under management."

The firms have little choice if they want to grow. For one thing, the increase in the number of buyout funds—to 470 today from 60 in 1990—has made raising money harder. "As the business exploded, more and more people rushed into private equity, which made competition for money fierce," says Richard I. Beattie, chairman of law firm Simpson Thacher & Bartlett, who helped KKR with its $30 billion takeover of RJR Nabisco in 1989 and remains an adviser to many private equity firms.

Stock prices have doubled in a two-year rally, making takeover candidates more expensive. And while deal activity is increasing, private equity firms are encountering more competition from corporate buyers with lots of cash. Blackstone, which is raising a $15 billion fund, committed only $550 million to private equity deals in the first quarter.

Blackstone's largest investment in the last 12 months was the $9.4 billion deal to buy 593 U.S. shopping centers in 39 states 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 in 2008, Schwarzman, 64, said during an April conference call with investors.

Co-founder Rubenstein has steered Washington-based Carlyle Group, ranked second by assets under management, into the fund-of-funds business by taking over AlpInvest, a Dutch company that spreads money for investors among buyout funds. Rubenstein, 61, also agreed to buy a majority stake in Claren Road Asset Management, a hedge fund that trades debt. "We're building new products and adding new geographies and people to give our clients more choice and asset-diversification options," he says.

KKR, created in 1976 by Kravis, Roberts, and Jerome Kohlberg, has ventured into underwriting stock and bond offerings, investing in infrastructure deals, making and buying loans, and, most recently, operating hedge funds.

Leon D. Black's Apollo Global Management, which completed a $565 million initial public offering in March, has been scouring European banks for what it calls "stranded assets," including $2 billion of nonperforming commercial loans, President Marc A. 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.

These 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 told investors in April.

Even so, private equity firms may not find asset management and real estate as profitable as buyouts. Private equity firms typically collect a 1.5 percent to 2 percent fee on assets under management and incentive fees equal to 20 percent 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.

Carlyle's Blue Wave Partners, the firm's first hedge fund, launched in 2007 and saw assets drop by a third, to $600 million, by 2008, as the market for mortgage securities froze. Apollo's real estate unit posted a first-quarter loss this year that the company said was tied to the purchase of Citi Property Investors from Citigroup (C) in November. "It's not hard to start or buy other businesses," says Blackstone President Tony James. "What's hard is creating businesses that are best at what they do."

Diversifying can be a way to smooth the boom-and-bust cycle of LBOs. That can be important to stock market investors, who often favor companies with consistent earnings. Three of the five biggest private equity firms have sold shares to the public since 2006, and Rubenstein said in May he's considering taking Carlyle public.

Results for investors who buy the shares of private equity companies have been mixed. As of May 31, KKR has gained 64 percent 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 has gained 62 percent in the past 12 months, its shares are still 44 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 (GS), is down 5.2 percent since March.

As they offer shares to the public, private equity firms may face skepticism from investors concerned that they are selling at a high point in the market. Says Harold Bradley, chief investment officer of the Ewing Marion Kauffman Foundation in Kansas City, Mo., which promotes entrepreneurship: "When the smart money is selling, I'm not convinced investors should be paying up."

The bottom line: The quest for new sources of revenue leads private equity firms into businesses that, while steadier, may be less profitable.

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