In the race among top private equity firms to diversify, Kohlberg Kravis Roberts & Co. LP has distinguished itself from its rivals in one very important way: It's the only private equity firm that's actually been underwriting stock and bond offerings, making it the only buyout shop with the audacity to step onto the investment banks' turf.

Since 2007, KKR Capital Markets, the 26-person-strong group led by former Citigroup Global Markets Inc. banker Craig Farr, has grown into an important cog in KKR's business. While KCM represents only a minuscule portion of the firm's income stream -- it brought in $79.1 million of fee-related income in 2010, compared to $2.1 billion of economic net income for the entire firm -- its activities have much greater implications for KKR's structure as a whole and its relationships with advisers and investors.

Farr, who had been co-head of North American equity capital markets for Citi, worked with KKR when it took public the debt vehicle KKR Financial in June 2005, and also helped structure its offering of units in a public buyout fund, KKR Private Equity Investors, in the Bailiwick of Guernsey in May 2006. He joined KKR after brainstorming sessions with Scott Nuttall, during which the two hit upon the idea of creating an in-house capital markets unit to manage the myriad debt and equity transactions made every year by the buyout house's portfolio companies.

Even this wasn't exactly a unique inspiration. Warburg Pincus and Blackstone Group LP already employed people to manage their firms' relationships with bankers and capital markets investors, and provide in-house counsel on market dynamics and trends. In the past few years TPG Capital, Hellman & Friedman LLC, Berkshire Partners LLC, GTCR LLC, Clayton, Dubilier & Rice LLC and Carlyle Group have also established similar groups.

None of those shops, however, moved beyond advising their firms on overall market dynamics to the next step: actually underwriting the deals themselves.

According to Farr, creating a broker-dealer affiliate that could underwrite deals would allow KKR to wean itself from its dependence on the investment banks, although he resists the term "disintermediation," noting that KKR never pretended it could underwrite deals entirely on its own, but wanted to act as a partner to the banks and ensure that KKR got the best pricing it could for its deals. "The theory we had was that if you had a team of people at KKR that were 100% focused on the firm, aligned with them as principals and owners, that those times where we felt the market got the better of the issuer would be less," he says.

The fact that KCM collects fees for its work -- as opposed to Warburg Pincus' capital markets group, whose costs are funded by the partnership -- has allowed KKR to build a fairly large and talented staff, he says.

Farr says that the group took a "build it and see" approach to KCM's growth, responding mainly to the needs of the moment, rather than working step by step through any master plan.

And in 2006 and 2007, at the height of the buyout boom, necessity dictated that KKR find some way of arranging equity syndicates to help the firm make acquisitions.

At the time, surging equity valuations and easy financing markets were encouraging private equity firms to come together in clubs to invest in companies such as SunGard Data Systems Inc., acquired by a club of seven PE firms for $11.3 billion, or hospital operator HCA Inc., bought by KKR, Bain Capital LLC, Merrill Lynch Global Private Equity and the Frist family of Tennessee for $33 billion.

While clubbing together allowed the firms to complete deals in sizes unimagined three years earlier, not many were happy with the phenomenon. "It was confusing to the limited partners because no one knew who actually sourced the deal, and it made operations more complicated because there were now two or three guys on the board, all with a potentially different view," says Farr. "So both strategically and economically, it made much more sense to have us find other sources of passive equity capital."

In 2006 and 2007, the group arranged equity from their limited partners and some hedge funds in deals such as Alliance Boots GmbH, Dollar General Corp., TXU Corp. (now Energy Future Holdings Corp.) and First Data Corp., acting as placement agents that allowed KKR to limit the size of the clubs that invested in the companies.

Then came the credit crunch and the financial crisis. Equity quickly stopped being a concern, and the buyout shops found the debt that had fueled the leveraged buyout boom was now the prized commodity.

KCM's first debt underwriting assignment came on a $1 billion financing for SunGard in September 2008. The debt helped the technology company finance its $624 million acquisition of a 64.5% stake in GL Trade SA.

In 2009, KCM sealed KKR's $1.8 billion acquisition of South Korea's Oriental Brewery Co. Ltd. from Anheuser-Busch InBev NV by finding committed financing to back the transaction. The capital markets team, led by Aren Leekong, obtained commitments from a group of eight lenders, and then used the commitments to win the company, even after bidding the least out of three finalists.

There was also the $1 billion financing of KKR and General Atlantic LLC's purchase in late 2009 of Northrop Grumman Corp.'s government-consulting unit, Tasc Inc.

Farr says that lenders, led by Barclays Capital, Royal Bank of Canada and Deutsche Bank AG, were initially reluctant to provide market-certain financing, insisting on market "outs" to protect their balance sheets. KKR's capital markets unit, however, mollified the lenders by persuading one of its private equity limited partners, the Canadian Pension Plan Investment Board, to put up $100 million for a bridge loan, reducing the banks' risk and allowing the acquisition to go through. "It wasn't just the cost of capital; it was the certainty and the terms for which we could do it, which allowed us to buy the asset," says Farr.

So why has KKR so far been the only private equity firm to adopt the broker/dealer strategy?

In a word: conflicts. Building a viable broker-dealer required the firm to come into direct conflict with some of its most important partners in finance.

For one, the Wall Street banks were not amused. According to several bankers, prominent executives such as the former and current CEOs of Morgan Stanley, John Mack and James Gorman, and Michael Cohrs, the former co-head of investment banking at Deutsche Bank, were annoyed by KKR's forays into the banking business, and questioned whether it was worth continuing their relationship as the firm began to agitate to get onto deals as an underwriter.

"They are walking a fine line, saying, 'It doesn't hurt, don't worry,' and 'We're not taking enough fees to matter to you,' " says one former bank executive. "But if the activity gets large enough, they cannot look at themselves and say, 'We're not a competitor.' At some point, they do become a competitor."

The irony of the situation wasn't lost on those involved: In 2004 and 2005, KKR had been one of the leading opponents of the investment banks' push into the private equity business. Its complaining about competition from banks such as Credit Suisse Group, Deutsche Bank, J.P. Morgan Chase & Co. and Morgan Stanley helped force the firms to shed those business lines. But now KKR is returning the favor by encroaching on the banks' fundamental businesses.

"It's one more hand in the pie," says one debt capital markets banker who worked with Farr's team on several recent deals. "The money comes directly from the major underwriters."

Both Farr and Nuttall, for their part, contend that KKR actually doesn't siphon very much money from the larger banks on any given deal. The largest impact is on marginal underwriters, which would be dropped in favor of KCM.

The two also point to the Oriental Brewery and Tasc deals as examples where their participation directly helped push the transactions to completion. And despite their misgivings, several bankers agree that the PE firm's willingness to share in the financing made it a little easier to fund their deals in the aftermath of the financial crisis. "It's been helpful to see them taking $100 million to $200 million of a deal," one banker says, noting that the firm has been particularly helpful in holding portions of revolving credit lines, a risk-capital-intensive but low-fee part of the capital structure detested by lenders.

Some bankers agree that KKR has been able to bend costs in its favor, particularly in recent refinancings of debt backing its struggling First Data payment processing company. "KKR does carry a pretty big stick," says one debt capital markets banker. "When calling around and putting the heat on investors, they can sometimes get people to come to them."

Also helping KKR is the fact that the effort is relatively small and so far no other PE firms have followed suit, tempering banks' fears of increased intrusion into their bread-and-butter businesses.

"They're small enough that people don't really care," says one banker. "But if they get much bigger, it will become an issue."

Perhaps no deal better illustrates the inherent conflicts than the $648 million initial public offering of semiconductor company Avago Technologies Ltd. Accounts of what unfolded, confirmed by several sources, show that KKR has irritated both banks and rivals with its investment banking initiative, but it has been able to use its clout as one of the largest fee payers to Wall Street to get its way.

KKR bought Avago with Silver Lake in 2005, and, when the two decided to take it public, KKR insisted that its capital markets group have a role in the offering. Most of the banks opposed the idea, says one source who worked on the deal, adding that Silver Lake, too, was resistant.

As the banker describes it, Silver Lake partner Kenneth Hao, who declined to comment for this article, convened the underwriters on the IPO on a conference call. With KKR excluded from the discussion, Hao asked each of the bankers to opine on whether KCM did anything more for the transaction than skim fees from the underwriting. The understanding among the bankers was that if the decision were unanimous, KKR would be kept off the syndicate.

But Deutsche Bank sided with KKR, sources say, having agreed ahead of time to defend the PE firm's participation in order to curry favor with the LBO house. That was enough to give KKR its first equity underwriting assignment.

For KKR, such episodes have proved the point that the capital markets unit is willing to butt heads with the established investment banking order for the benefit of its portfolio companies.

Perhaps the most important relationships for any PE firm are those with its limited partners -- the pensions funds and other financial institutions that provide the money for the LBO funds. These may have been expected to look askance at the KCM initiative, given the conflicts inherent between an issuer that wants to limit funding costs and an underwriter seeking to maximize fees.

There are signs that KCM has been able to pacify the LPs, although some continue to express reservations. As one KKR LP puts it: "We're always trying to look at where is the economic benefit derived. And are we on the same side of that trade? Right now, if you look at KKR, the majority of the economic benefit is derived from the classic PE activities. That's good for us. We're on the same side of the house. But if that starts to shift, that creates the question, is there still an alignment here?"

And, despite KCM's success in establishing a foothold in the business, there are limits to how much it can push, particularly in the face of opposition from other PE firms.

For example, KKR was not one of the underwriters on the Nielsen Holdings BV and HCA IPOs because its partners on those deals objected.

Still, KKR's move into underwriting has its share of admirers. "Their move is brilliant," says one financial sponsors banker, who estimates that KKR was at one point paying as much as $1 billion a year in fees to the Street. "Those fees have traditionally been their currency for dealflow, but I think they have correctly looked at those fees and realized some percentage of those fees simply weren't returning fair value. In other words, they were giving fees, say, to the bottom 20% [of underwriters], and they weren't getting anything in return for it. Not better execution, not more ideas, not better access. So their idea was, let's capture those fees. And now that KKR is public, that fee stream gets capitalized at some PE multiple, and that generates value for them and their investors."

Is it only a matter of time before others follow? One source says there are rumors of another private equity firm looking at the idea, but most have so far hung back. Blackstone CEO and chairman Stephen Schwarzman, for example, in the past has disavowed any move into underwriting, chiefly because he didn't want to sink Blackstone's money into a low-margin business. But KCM, which operates without a trading desk, as banks have, produces good returns on its capital.

As the history of the PE industry shows, when one firm is successful in any given area, it doesn't take long for the competition to follow suit. Farr, for one, thinks it's inevitable. "We've taken some of the arrows," Farr says. "Others are likely to follow."

See related story, "Reinventing KKR."