A host of private equity firms have been considering creative ways to raise cash, both before and since The Blackstone Group’s mid-June IPO. But the experience of Blackstone, whose initial stock price has fallen about one-third, in the midst of a credit market squeeze, gives pause. Much depends on the approach to raising cash. The wrong course could erode not only valuations, but also private equity’s real advantage—its active investor mindset.

Private equity firms are tapping the public markets in two different ways. The first is offering a piece of the management company. The Chinese government and other investors who secured shares in Blackstone’s IPO, for instance, ended up owning about 20% of Blackstone, entitling them to a share of profits from management fees and carried interest, with no voting rights.

The second approach is floating shares in a private equity fund itself, which the management company then invests. To get access to more capital, the fund can issue more shares, such as a rights issue for a public company. These shares trade and value the fund and its investments like any other public company. KKR Private Equity Investors LP and AP Alternative Assets (managed by Apollo), for example, both trade on Euronext in Amsterdam.

A handful of firms, including London-based 3i Group and Onex in Toronto, have taken a hybrid approach, with relatively good returns. Other leading private equity firms have looked at floating shares in either the management company or their funds. KKR filed for an IPO in July 2007, then filed an amended version of its prospectus in mid-November.

The implications of the two approaches are different. The money raised by selling a stake in the management company is not a source of “evergreen capital". Rather, it lets the firm diversify its ownership without radical changes in the way it does business—at least, that’s the expectation of how such public offerings will be treated by regulators. Thus, some proceeds from the Blackstone IPO will help fund expansion in China and elsewhere, but much of it will be used to cash out some holdings of the firm’s partners.

Selling shares in a fund, on the other hand, holds the potential for some big opportunities—but also contains bigger risks to private equity’s model. The upside is that the firms don’t need to waste time and precious human capital on fund-raising, a time-consuming process that takes some of the vital players in a private equity firm off the field every few years for months at a time. Another benefit is differentiation. Money, after all, is rapidly becoming a commodity, and leading private equity funds are seeking ways to stand out even further from the crowd. Top funds want to do deals of almost any size on their own and apply their particular approach to improving company performance without dilution by a consortium of investors.

Access to public equity also means that funds can be more nimble pursuing deals in different parts of the world with different types of assets. In Japan, for instance, firms often need to structure deals with more debt products; in India, minority equity stakes are the key to entry; in China and Brazil, the current focus is on infrastructure investments. Pursuing those opportunities involves a range of risk and return that reaches beyond the typical Limited Partner agreements private equity firms strike with institutional investors.

Finally, the leading funds have developed their own brands. Taking a page from their own playbooks for growing the value of their portfolio companies, they see ways to use their brands to raise more capital, extend their range and pursue more opportunities.

The danger is that this type of public shareholding will constrain the funds’ ability to act like owners. As their public float grows, so do the risks that compliance with regulations and reporting requirements will slow or stall private equity’s fast attack.

Even more serious is the risk of eroding private equity’s activist investor mindset. After all, that’s the real advantage private equity players hold. They invest with a thesis for improving profits and performance in a given business in three to five years, instead of taking a quarterly view of performance improvement. They create a blueprint for change, detailing what, how, when and where to drive the few key adjustments in a company’s organization and operations.

They also measure only what matters and measure it often, to understand whether a business is moving in the right direction and gaining speed. They hire, motivate and retain hungry managers, stimulating them to think like owners. And they make equity sweat: the average private equity firm finances about two-thirds of its assets with debt versus 40% at a typical public company. Scarce cash forces managers to redeploy underperforming capital.

When private equity succeeds, it presents an extremely compelling business model. Over the 37 years from 1969 to 2006, the top quartile US private equity funds enjoyed internal rates of return of more than 35% on average, with some earning triple-digit rates of return. The moves by private equity firms to tap public sources of funds are in some ways the natural evolution of an industry that continues to grow. But the industry’s leaders will need to move carefully to preserve what’s unique and effective about private equity.

Orit Gadiesh is chairman of Bain & Company, and Hugh MacArthur is director of Bain’s Global Private Equity Practice. They are the authors of Memo to the CEO: Lessons from Private Equity Any Company Can Use, to be published in February 2008 by HBS Press. Sri Rajan, a Bain partner in New Delhi, is a leader in the firm’s India private equity practice. Comments are welcome at theirview@livemint.com