Bubble Fund Finds Itself Back at Square One –

On the plus side, Clearstone Venture Partners’ first fund did very well in spite of its heavy emphasis on Internet deals. On the minus side, the firm’s second fund is in the red because of its heavy emphasis on Internet deals. Clearstone will have to reconcile those conflicting results if it is to be successful in raising a third fund.

The Santa Monica-based venture firm-formerly known as Idealab Capital Partners-is in the early stages of fund-raising. Its partners declined to talk about their plans, citing SEC rules, but a knowledgeable source says the fund has a target of about $200 million and will focus on early stage information technology and enterprise software deals, in addition to being “opportunistic” about consumer technology plays.

Because it began as an Internet-focused fund and is unproven as a technology investor, Clearstone is pitching itself as an emerging manager, says a source close to the firm. It’s finding “traction” among prospective LPs, but raising a third fund “is not a slam dunk,” the source says.

“Fund-raising is challenging for everyone, unless you’re perceived to be in the Top 5 firm group,” says Mac Hofeditz, a principal at Probitas Partners, a San Francisco private placement shop. “The biggest challenge is that it’s not on your timetable-it’s on LPs’ timetable, and there are a lot of funds vying for LPs’ time and attention.”

Getting the attention of LPs is the tricky part. “Clearstone’s challenge is that the people who backed them in the beginning did so for a set of reasons that don’t exist anymore,” says an LP who invested in the firm’s first two funds.

He was referring to Clearstone’s initial focus as a fund developed to support Internet companies spun out of Bill Gross’s Idealab incubator. The Internet guru and his incubator were general partner in the funds, which had the distinction of getting a first pass at Idealab companies looking for venture backing. Back in the boom times, that made Clearstone very special, indeed, since Idealab launched several hot Internet companies, including online guide CitySearch, eToys, search engine GoTo.com, and Internet service provider NetZero.

Later, as the bubble began to burst-and once-hot companies like eToys stumbled into bankruptcy-Idealab became a liability, and Clearstone ended its affiliation with the Internet incubator.

Clearstone’s Idealab affiliation paid off big for its first fund, which held a final close in early 1999 and topped out at $105 million. It had several big hits, including the IPOs of GoTo.com, MP3.com and NetZero, resulting in a net internal rate of return of 156% as of Sept. 30, 2003, according to the California Public Employees’ Retirement System (CalPERS).

CalPERS is an indirect investor in Clearstone’s first two funds through its California Emerging Ventures (CEV) program, which is managed by fund advisor Grove Street Advisors. CEV was set up to get CalPERS into venture funds it previously had no relationship with. Typically, if CalPERS is happy with the results of CEV investments in a VC firm’s first two funds it will invest directly in the firm’s third fund, instead of investing indirectly through CEV/Grove Street. CalPERS has not yet decided if it will invest in Clearstone’s third fund, but it is “very favorably disposed,” says a source close to the giant pension fund.

For the $2.5 million that CEV put into Clearstone’s first fund, it has gotten back $5.99 million in cash and has other interests worth another $800,000, according to CalPERS.

Clint Harris, founder and managing partner of Grove Street, gives Clearstone high marks for being “much faster than rest of the industry to distribute” from its first fund. “It gave us the opportunity to get out early [from some of the portfolio companies that went public].”

“That was a smart thing,” Harris adds. “They were very quick to realize the Internet game was over and they diversified very quickly.”

But not quickly enough to avoid getting burned from several Internet deals in its second fund. Fund II wisely invested in PayPal, which went public and was later acquired by eBay, but the fund apparently didn’t make enough off of the PayPal investment to offset losses on other Internet deals. Among the defunct Internet startups that Fund II invested in were AdExchange, BestOffer.com, e-Standard, FreeMusic.com, HomePage.com and Nutrapeak.com.

Fund II, a $364 million fund, raised in December 1999, had a negative net IRR of 18% as of Sept. 30, 2003, according to CalPERS. CEV committed $20 million to the fund, of which $12.6 million has been drawn down. Clearstone has returned just $2.98 million in cash, and CEV’s other interests are valued at $4.7 million, CalPERS’ performance report shows.

The thing that Clearstone has going in its favor is that most vintage 1999 venture funds are in the red. In fact, the benchmark for vintage 1999 funds is a negative IRR of 11.2%, according to Thomson Venture Economics (publisher of Venture Capital Journal).

Another selling point for Clearstone’s new fund is that its partners exercised restraint when they raised their second fund. That fund, which had an initial target of $250 million, had enough interest to raise $600 million, Clearstone co-founder and Managing Director Bill Elkus told VCJ back in 1999.

Also, Clearstone’s general partners can honestly tell LPs that they feel their pain. The GPs personally committed $30 million to Fund II (or 8% of the total), Elkus said at the time.

Fund II’s LPs include the Massachusetts Institute of Technology, Goldman Sachs, J.P. Morgan, HarbourVest Partners, Horsley Bridge Partners, the California Institute of Technology, Invesco Private Capital, Mellon Ventures and the Los Angeles County Retirement Association.

Email: lawrence.aragon@thomson.com