When Jason Green cofounded Emergence Capital last year, “we were wondering if this was a big mistake,” he confesses. His new firm, started with partners Brian Jacobs and Gordon Ritter, is focused on early-stage investments. It is gambling, while veteran outfits, still shaking off the wounds of the industry’s years-long turmoil, are playing it safe.

How many could the team hope to win over, after so many in the industry were burned in the tech bubble and bust?

As it turned out, a lot.

Emergence is part of a new crop of VC firms formed to meet a demand that never waned despite war, recession, post-bubble investor fear, and Webvan.

And the firm’s founders have reason, albeit small, to be optimistic.

Venture capital levels in the U.S. are just now beginning to stabilize after years of declines. Though the $4.3 billion invested in the third quarter of 2004 was a 27 percent drop from the previous quarter, it’s about equal to the same period last year, according to MoneyTree Survey by PricewaterhouseCoopers (PWC), Venture Economics, and The National Venture Capital Association.

In the first nine months of 2004, $15.3 billion was invested, a significant increase over the $13.3 billion for the same period last year. At the current pace, PWC expects 2004 levels to easily exceed the $18.7 billion invested in 2003.

Even with the numbers looking up, the VCs of Emergence Capital are well aware that they will have to stand apart from the old guard. Smaller, and focused on a narrow set of specific industry sectors, and largely helmed by veterans with operating experience, they’re boldly bringing VC back to its roots: risks.

Counterintuitive capital

Mr. Green and Mr. Jacobs realize that they’re on dangerous ground. Numbers for the past few years show that VC funds have lost anywhere from 5 to more than 50 percent of their value. Limited partners, or LPs – the U.S. pension funds, endowments, funds-of-funds, and private investors who fuel venture capital – are spooked.

The “transparency” issue also looms large. Survivors of the boom’s delirious estimates want more access to fund performance numbers. Several years ago, public pension funds like the mammoth California Public Employees' Retirement System (CalPERs) and the University of Texas Investment Management Company (UTIMCO), the second-largest university endowment in the United States with $14 billion under management, began publicly disclosing the performance of venture funds – and how much they were making or losing on each investment.

Fearing for their privacy, some top-tier venture funds have refused to accept any more money from these public institutions. The upshot: public LPs now cast a wider net for venture funds in which to invest.

As Mr. Green and Mr. Jacobs discovered, some LPs were actually willing to pour more money into venture capital, increasing the total assets under management allocated for private equity from the usual 3 percent to 4 or 5. The thinking went something like this: in 2003 the market hit bottom and with nowhere to go but up, more good times were just around the corner.

This year, 23 percent of limited partners actually plan to increase their private equity holdings, according to Greenwich Associates, a research firm geared toward institutional investors, based in Greenwich, Connecticut. That’s a significant change from the past year, when private equity allocations were down a fraction of a point.

And a few percentage points do not amount to small change, considering that an average pension fund, like that of the State of Oregon, has close to $50 billion under management. As in the bubble years, LPs seem increasingly willing to wager a larger percentage of their mammoth funds on venture capital because of the potential for higher payoffs. 

Never too young, or too rich

VCs who retreated to safer ground aren’t cashing in on the LP infusion. Instead, it is fueling the younger crowd – firms that move fast, showing up the bureaucratic and slow-moving culture of large, established firms.

Enter Mr. Green and Mr. Jacobs, refugees from established venture firms U.S. Venture Partners and St. Paul Ventures, respectively. Their third partner, Gordon Ritter, was vice president of IBM’s small business division before building the platform behind Salesforce.com.

They formed Emergence as a counterpoint to what they say were the rising inefficiencies of large, lumbering firms.

“We became a bit disillusioned with the ability of a large firm with 10 or more partners to make effective decisions,” says Mr. Jacobs. “Especially when trying to manage a capital pool of a billion dollars or more.”

The firm landed their first major institutional commitment from CalPERS after just nine months, speedy for a new firm competing against a long list of established players.

“One of our investors called us the Roger Bannister of venture capital: we broke the four-minute mile as a new venture firm raising money,” Mr. Green says. “And now that we've done it, others know that it can be done and will follow us.”

In August of this year, Emergence officially closed their first fund of $125 million, a very respectable size for a first-time fund. Besides CalPERS, participated blue-chip LPs included the University of Michigan, The Pew Charitable Trusts, and Morgan Stanley Investment Management.

Leading the curve

Another factor contributing to a surfeit of LP funds is the controversial venture capital “overhang,” a cash glut of up to $100 billion (estimates vary) lying dormant while cautious firms assess investments, and try not to spark another fatal bubble. In addition, new pension funds from Asia and Europe have entered the private equity asset class for the first time.

No sufficient data exists on how much money these new LPs are adding to the mix, but VCs and LPs interviewed for this story confirmed foreign investors are starting to have a serious impact on the market. The tables have turned: general partners at top-tier firms are fending off eager LPs.

“There’s plenty of money available from the LP side to invest,” says Mike Kelly of Hamilton Lane, a fund-of-funds headquartered outside of Philadelphia. “Yet while established institutions with a lot of money can invest in top VC groups, smaller ones can’t really invest in those good groups.”

New rules of engagement

With competition growing, LPs are using unconventional thinking in their quest to place capital. One such strategy is sniffing out new, up-and-coming funds with Kleiner Perkins-style potential. 

“A lot of the more sophisticated investors in VC funds are realizing they have to find new teams they can go with, hoping to find the next rising star,” says Mac Hofeditz, principal for Probitas Partners, a San Francisco-based firm that connects VCs and LPs.

State pension funds like CalPERS have even instituted programs to proactively target emerging funds. But while getting creative is often a positive sign, LPs who move down the food chain to back emerging funds may be taking too great of a risk and are, in the words of Mr. Kelly, “in danger of creating another bubble in the venture world.”

University of California-San Diego professor Paul Kedrosky, who specializes in venture capital, backs Mr. Kelly’s fears. “To justify the amount of capital flowing into the category,” he says, “you’d have to believe we’re about to re-enact the late ‘90s.”

Those fears might be premature. In 1999, for instance, 391 venture firms raised an eye-popping $59.2 billion, according to industry research firm Venture Economics. By contrast, a mere 85 VC firms have raised $5.8 billion this year, as of August. 

Why such a huge discrepancy? One reason is that around 1999, venture funds suddenly ballooned from $200 to $300 million in committed capital, to $1 billion to $2 billion in committed capital. But in the past few years, VC firms have discovered that such an inflated model is untenable. As these billion-dollar megafunds return to the market, they’re now raising funds a fraction of their former size.

“There’s a lot of demand out there on the part of LPs, but the supply is severely constrained,” says Josh Lerner, professor at Harvard Business School. “Not only are fewer VC firms raising new funds, they are asking for smaller amounts of money. If there’s a demand and there’s a lack of supply, more supply will spring up.”

New kids on the block

In addition to Emergence, about a dozen other firms have sprung up. Each has strong industry experience and is focusing on a few specific industry areas.

Orchid Partners in Boston, for example, is led by founders with decades of operational experience and focuses on early-stage technology and retail companies.

“We’ve done 40 angel deals among us, and we have a great track record doing that, though we’ve never had a fund, per se,” says David Friend, an Orchid partner and serial entrepreneur whose companies have sold for hundreds of millions.

Many limited partners who would have snubbed a firm like Orchid a few years ago are now interested in investing, because the bigger VC firms have cut back fund sizes. LPs are realizing the need to start making bets on new, emerging funds to remain players in the market.

“We’re actually starting to see some conservative LPs knock on our door,” says Mr. Friend. The firm is looking to raise $150 million, and is nearing a first close of $75 million. 

Emerging firms are also winning over LPs by rethinking old models. David Helfrich and Terry Garnett, until recently, were old-school venture capitalists at Comm Ventures and Venrock Associates.

They saw big money going into venture capital and not as much coming out, so instead of investing in new startups, they founded Garnett & Helfrich, a firm that rehabilitates neglected portions of large businesses, helping them reach their full potential.

In venture, for every new company, there are dozens of startups being funded by somebody else competing for the same market. But the orphaned firms that Garnett & Helfrich buy out often have a head start, with revenue streams of $50 million and several marquee Fortune 100 customers.

The G&H approach is music to LPs’ ears: the limited partners in the $250 million fund they closed last spring include the Harvard and Stanford endowments, and prestigious funds-of-funds like Grove Street Advisors.

What’s more, due diligence is critical and more rigorous than ever among LPs. G&H, for example, had to provide potential LPs with a 70-page book of every deal the two managing partners had ever been involved in. Solid strategy and track record alone aren’t good enough. A key litmus test for LPs, says Hamilton Lane’s Mr. Kelly, is the team itself: what is their combination of skills, and how well do they work together? 

It’s not as if every new firm has experienced similar success. One partner at an emerging firm, who spoke off the record, noted that limited partners are giving deeper scrutiny to new funds, but he believes some of the bigger-name funds aren’t being subjected to the same kind of diligence.