A Fund Is Born: Grumpy LPs, lost luggage, too much airplane food. Oh, the pain of raising a first-time fund. Three first-timers share the lessons they learned on the long and bumpy fund-raising trail.

Everyone remembers their first time-the nervous anticipation, the performance anxiety and the nagging question: Will I be respected afterward? We’re speaking, of course, about raising a first-time venture capital fund.

First-time funds aren’t necessarily raised by first-time managers. Rather, they’re raised by new venture firms, which are more likely than ever to be run by experienced general partners. In the past year, many seasoned GPs have turned free agents, as established firms have returned to the fund-raising market and restructured partnerships. The restructuring has resulted in several partners leaving top-tier firms-voluntarily or otherwise-and opening their own shops.

Case in point: Rob Coneybeer, Tod Francis, and Ravi Mohan last year exited New Enterprise Associates, Trinity Ventures, and Battery Ventures, respectively, as those firms prepared to hit the fund-raising trail. Shortly afterward, the trio formed an as-yet-unnamed firm that will begin raising a first-time fund this summer. The partners are no rookies. Collectively, they have returned $1.2 billion on $400 million of invested capital over the past decade, says Mac Hofeditz, a partner at Probitas Partners, the new

firm’s San Francisco-based placement agent.

New firms are also spinning out of banks and corporations, which often have an early bead on under-funded niches in their industries. One example is New York-based HealthPoint Partners, which was launched last year by health-care merchant bank HealthPoint LLC. “They brought us a model which we thought had high potential: a targeted investment in orthopedic devices that are going to be much in demand as America gets older,” says Jon Bauman, executive director at the Teachers’ Retirement System of the State of Illinois, which allocated $20 million to the new firm’s $200 million fund.

Institutional investors are increasingly on the lookout for promising first-time fund managers. As fund sizes shrink among top-tier firms, pension funds and endowments have fewer places to put their money. Therefore, many of them have started “emerging manager” programs in hopes of discovering the next Kleiner Perkins Caufield & Byers or Sequoia Capital. The California State Teachers Retirement System led the way last year by announcing it would allocate $100 million to “new and next generation” private equity firms over a 10-year period.

But for most new firms, the increased interest hasn’t made raising a first-time fund much easier. “Most people don’t do first-time funds because it’s too much work,” says Erica Bushner, managing director at GKM Generation Funds, a fund-of-funds. Many investors would rather go with a known entity than slog through due-diligence reports on three managers with disparate track records.

For that reason, raising a first-time fund typically takes more than a year. That may seem especially long, considering many funds were raised in a matter of weeks during the Bubble, but that’s the kind of time VCs had to spend fund-raising before the heady days of the Internet. For example, it took Novak Biddle Venture Partners nine months to raise its first fund back in 1997 – and that was for just $30 million. It needed a mere five days to lock up $150 million for its fourth fund this year, but that’s to be expected for a firm that has returned in excess of 50% on all three of its previous funds (see sidebar, page 35).

The long hours required to raise a brand new fund haven’t put a damper on ambitious VCs. More than 40 first-timers are out pounding the pavement. Most of them are targeting health care, but a handful is going after niches like energy, so-called “clean” technologies and even Hispanic-owned businesses.

To find out what it takes to raise a first-time fund, Venture Capital Journal took a close look at three new firms that recently closed funds greater than $100 million. From their experiences, some tips for other first-time fund-raisers emerged:

* Differentiate yourself with an investment

strategy that’s unique.

* Be prepared to show a record of significant

returns or operating experience.

* Highlight special expertise or contacts that

give you a leg up on competitors.

* Pace yourself for dozens of meetings over a

year or more.

* And, most importantly, don’t give up.

Show Me the Money

It all started with the famous Jerry Maguire memo. In early 2002, Art Marks began circulating a letter among his contacts describing a new kind of VC firm based on the idea that less is more. A year earlier, he had retired from New Enterprise Associates after an 18-year career during which the number of new companies funded annually by VCs grew from 750 to 3,000, a rate Marks found unsustainable.

“The recent flood of capital into our industry has produced a disparity between the amount of capital deployed and the ability of partnerships to effectively manage it,” Marks wrote. His solution boiled down to one word: moderation. Particularly in fund sizes and rates of investment.

From that principle, Valhalla Partners was born in McLean, Va. Marks was joined by two other general partners, Gene Riechers and Hooks Johnston, a duo that founded Friedman, Billings, Ramsey Group’s venture arm. Together, the three partners had averaged about a three-times return on capital invested in 90 companies throughout their careers. Still, that alone was not enough to sway limited partners. LPs also wanted to see a compelling strategy.

Valhalla prefers mid-Atlantic startups, though it casts its net outside the region, too. It invests only at early stages, avoiding the recent trend toward highly competitive later-stage deals. The partners focus on categories they know best: software, hardware and communications – not health care. They will invest in 15 to 20 companies over a three- to four-year period.

With that rather safe strategy in place, Valhalla hit the fund-raising trail in June 2002 with the goal of raising $150 million. Then the team considered a fourth potential general partner. Figuring it would take 3 1/2 years for four people to invest $50 million each, the firm upped its target to $200 million. That, however, proved too ambitious.

That year (2002), only 32% of all venture capital raised went to first-time funds, and the total amount raised for all funds dropped 76% from 2001, according to Thomson Venture Economics (publisher of VCJ). “The fund-raising environment when we went out was arctic,” Marks says. “People would have us in just to beat up someone from the venture business.” For two years, limited partners had been hearing a steady drumbeat of bad news from general partners, and few of them were feeling generous.

It was a long haul involving lots of travel and one case of lost luggage. Over 18 months, the partners presented to more than 125 prospects, many of whom were still recovering from recent venture-investing disasters. Marks recalls a typical meeting: “You’d have some relatively young people at a university, and their investments had blown up, and now the powers that be were jerking everybody around.” When Valhalla met with one well-known fund-of-funds, 10 minutes into the partners’ presentation, the lead decision-maker asked, “Aren’t you the real estate guys?”

Valhalla tried raising money in Europe, but trips there proved fruitless. At one point, the partners considered expanding their fund as a Small Business Investment Company, but they chose not to go that route because they didn’t like the terms. Using a placement agent was another option, but Valhalla’s budgeted management fee made paying an agent difficult.

The turning point came when Valhalla hit pay dirt with J.P. Morgan and HarbourVest Partners, which responded to the new firm’s strategy. “They are exploiting two advantages in the market, which are a less-served geography and a workload that gives them capacity to be intensely active in their portfolio companies,” says Ted Clark, managing director at HarbourVest. With two anchor tenants on board, other limiteds followed.

Also persuasive were Valhalla’s terms. True to Marks’ NEA roots, Valhalla took a budgeted management fee in exchange for a carry escalation that is based on performance. If the partners return more than three times capital, their carry increases from 20% to 25 percent. In addition, the partners showed confidence in the fund by pledging their own money – about $20 million, or 12% of the fund.

In December 2003, after an 18-month campaign, Valhalla held a final close at $172 million, coming in 14% under its goal. “We were beyond critical mass,” Marks says. “We wanted to stop fund-raising and focus on doing deals.” All told, the firm racked up about 20 investors, including DuPont, Investco, Lockheed Martin, Quellos Group and U.S. Trust.

Since then, Valhalla has invested in three IT startups on the East Coast. As a memento from their first-time fund-raising experience, the partners keep a quote from Winston Churchill posted in their office: “Never, never, never give up.”

One Word: Plastics

You won’t hear much talk about rotary extrusion blow-molding equipment on Sand Hill Road. That’s the beauty of Inverness Capital Partners, which uses its partners’ pedigree in industrial technologies to fund sectors most VCs don’t pretend to understand.

Based in Philadelphia, Inverness was founded in 2002 by Ken Graham of the Graham Group, which is a collection of industrial and investment businesses owned by Donald Graham and his family. In the 1960s, Graham developed patents on plastic-packaging equipment and founded several successful companies.

In 1998, the Graham Group sold its majority interest in Graham Packaging to buyout firm Blackstone Group for $1 billion. The sale was part of a plan to transition the Graham Group’s holdings from industrial businesses to investment businesses. The group has a long history of investing in private companies and private equity funds, including Graham Partners, a $225 million buyout fund. Starting a venture firm seemed like the next logical step.

“Our focus is growth and expansion capital for innovative industrial companies,” says Ken Graham, managing principal at Inverness.

The firm targets companies with $5 million to $25 million in annual sales in sectors like advanced materials, robotics and manufacturing IT. Inverness provides capital, contacts and operating experience to help the fledgling companies expand product lines and distribution channels.

The four-manager firm plans to invest $4 million to $8 million per company from a $125 million fund, two-thirds of which comes from the Small Business Administration.

When Inverness started fund-raising in May 2002, it intended to raise just $90 million. But by its first close in June 2003, it had locked down $100 million and was oversubscribed. Not that the process was easy. When investors first heard the pitch for an expansion-stage industrial fund, some scratched their heads. “I would tell them, Don’t invest in us if you think you’re meeting with a 1-in-10, swing-for-the-fences venture guy,'” Graham says.

Unlike early-stage funds, in which one home run makes up for nine strikeouts, Inverness wants to consistently knock out singles and doubles. The fund’s best-performing company may not return a multiple as high as an early-stage fund’s top performer. But because expansion-stage companies are less risky, the firm expects few severe write-downs. Therefore, the fund’s overall returns could match or outperform those of early-stage funds, Graham says.

After securing initial investments from the general partners and the Graham Group, Inverness won commitments from two large industrial corporations: Air Products and Chemicals (NYSE: APD) in Allentown, Penn., and Bekaert (Euronext: BEKB) in Kortrijk, Belgium. To them, the portfolio companies of Inverness are research-and-development projects. “We’re looking for opportunities where we can make synergistic investments,” says Buddy Eleazer, manager of new business development at Air Products and Chemicals. The two strategic investors also help source and evaluate Inverness’ deals.

In September 2003, Inverness held a final close of $125 million from more than 20 LPs, including Wilmington Trust, Mercantile Bancshares, Camden Funds, MBNA, and the Pennsylvania Department of Community and Economic Development. The entire fund-raising process took 16 months.

Early on, the partners tapped key individual investors like Bob Lessin, vice chairman at Jeffries & Co., and Rick Snyder, former president and COO of Gateway Computers. Next, they went to mid-size banks and funds-of-funds. Finally, they visited pension funds and endowments, knowing many of them didn’t invest in first-time funds but wanting to lay the groundwork for future fund-raising.

“One thing I would advise for anyone starting a first-time fund is to really have a differentiated offering,” Graham says. “There ain’t a lot of venture capital chasing growth- and expansion-stage industrial deals.”

Overall, Graham and his partners took about 150 meetings from May 2002 through September 2003, traveling across 10 states, but mostly focusing on Pennsylvania. “We had about a 15% hit rate given our plus-minus 25 investors,” Graham says.

Sometimes the hits came from the strangest places. “I was sitting in a chair at the eye doctor’s, tired and not in the mood to talk – exhausted from the fund-raising trail,” Graham recalls. “The doctor insisted that I tell him the Inverness story, and it turns out he had a friend from college who might be interested in an industrial technology fund.'”

In fact, the doctor’s friend sat on the board of Bekaert. “I was on a plane to Brussels a week later, pitching to top execs at Bekaert,” Graham says. “They made a large investment and went on to become a pillar investor and a true strategic limited partner in the fund.”

All because he needed to get his eyes checked.

Quaker State

For Ira Lubert, there are not many firsts left in private equity. He has raised buyout funds, real estate funds and mortgage mezzanine funds. And he’ll have raised his second first-time venture capital fund by the end of August. That’s when Philadelphia-based Quaker BioVentures will hold a final close on a fund between $250 million and $300 million, ending a 2 1/2-year fund-raising odyssey.

Lubert, who previously co-founded Radnor Venture Partners (renamed TL Ventures), started Quaker in 2002 after closely examining the mid-Atlantic region. The area is home to some of the largest recipients of funding from the National Institutes of Health. It has a high concentration of teaching hospitals. It has the most pharmaceutical companies in the United States. And it has a handful of life-science VC firms, none of which invests exclusively in its own backyard.

“We thought there was a tremendous need for a dedicated life-science fund investing primarily in the mid-Atlantic region,” Lubert says. “And a lot of our future investors, thank God, agreed with us.”

Sort of. While Quaker was able to meet its official PPM target of raising $200 million by January 2003, Lubert told VCJ back in the summer of 2002 that the fund planned to hold a final close on $300 million by the start of the New Year (see “Quaker Aims for $300M,” August 2002 VCJ). But that amount proved too ambitious, particularly since Quaker was a first-timer seeking capital in a post-Bubble market. Seventeen months later, the firm isn’t sure if it will hit the larger target.

Quaker set a high target because life-science companies are notorious for requiring lots of capital before generating significant income. “We said we wouldn’t do this fund unless we could raise at least $200 million,” Lubert says. “You need scale to be able to effectively manage your investments over multiple investment rounds.”

Lubert is confident that Quaker will close within $50 million of its target by August, but he concedes that he encountered the same chilly climate as other recent fund-raisers. “The whole private-equity sector was not very receptive when they were looking at some of the returns from 1999 and 2000,” he says. “We also ran across several prospects who said, We just don’t invest in first-time funds.'”

In addition to Lubert, the firm has two general partners: Brenda Gavin, former president of GlaxoSmithKline’s life-science venture arm, and Sherrill Neff, former president and COO of Neose Technologies, a life-science company. The partners target early-stage companies and plan to invest $5 million to $20 million per company in multiple rounds.

Since January 2002, the Quaker team has met with roughly 40 investors in seven states. The firm has had the most success with mid-Atlantic investors, who like the fund’s regional focus. Among the funds’ limited partners are the Pennsylvania Public School Employees’ Retirement System, the Pennsylvania State Employees’ Retirement System, and the City of Philadelphia Board of Pensions and Retirement.

One feature that has appealed to investors is Quaker’s affiliation with Independence Capital Partners, which allows it to maintain low overhead. Independence is a holding company that operates a shared back office for Quaker and Lubert’s three other investment companies: Lubert Adler, L.L.R., and L.E.M. Independence outsources functions like accounting, finance, and risk management to the four entities at cost and does not own any part of their funds. The arrangement allows Quaker to share the cost of IT systems and 15 employees.

Quaker is already putting its oversubscribed fund to work. In March, the firm co-led a $63 million series D investment in Eximias Pharmaceutical of Berwyn, Penn. “It’s the largest life-science round ever closed in Pennsylvania,” Lubert says. How’s that for a first-time fund?

Justin Hibbard is a San Francisco-based freelance writer who specializes in covering Silicon Valley’s venture capital and technology businesses. He can be reached at justin_hibbard@pacbell.net.