Tougher competition for deal flow in 2004 and a flurry of year-end investments are signaling that 2005 may be a robust year in the venture capital market.

Two local deals in December illustrate the point: eBay Inc.’s $415 million purchase of Santa Monica-based Rent.com and a $110 million investment in Pasadena-based eHarmony by two venture firms.

Though 2004 has been characterized as a turnaround year, VC investors seem confident that the pall hanging over the venture community since the dot-com bubble burst in 1999-2000 has lifted. Money continues to flow from large institutional investors who are chasing higher returns from riskier asset classes.

Moreover, the higher stock market has helped create so-called “liquidity events,” allowing VCs to exit investments they made in start-up companies several years ago by being bought out.

“It’s been quite strong in 2004 with a dramatic shift in activity,” said Jim Gauer, general partner at Palomar Ventures in Santa Monica. Palomar experienced strong demand for its third fund, Palomar Ventures III, which was oversubscribed when it closed in October with $225 million. Gauer said the goal was to raise $150 million to $200 million.

“There’s a feeling that the Southern California market is underserved by VCs, so activity has picked up,” he said, adding that big institutions view Los Angeles as a way to diversify out of Silicon Valley, where the cost of investments has jumped dramatically.

Like most venture firms, Palomar’s role is similar to that of a talent agent in the movie business. The company helps spruce up young companies, often as part of a syndicate of venture capital investors. They will help beef up management and strategy with the aim of selling the company at a higher price later on.

Palomar’s investors, or limited partners, include the California Public Employees’ Retirement System, the University of California and JP Morgan Chase & Co.

Numbers tracking venture capital activity in the fourth quarter will not be released until mid-January. For the third quarter, venture-backed firms in Southern California raised $502.2 million, a 19 percent jump from the $407.5 million in the April-June period, according to VentureOne and Ernst & Young. Investment activity was up 4 percent from the third quarter of 2003, when local firms raised $482.1 million.

Region lags

Los Angeles has never been a standout for venture capital compared with San Francisco, San Diego and Boston. But it attracted more interest last year.

John Morris, managing director of GKM Ventures, said companies in Northern California are commanding a 15 percent to 20 percent premium compared with those in Los Angeles. As a result, investors have been scouring Southern California for prospects and bidding up prices here as well. The Bay Area’s depth and quality of start-up companies’ management teams tends to be stronger because the area has a larger pool of senior-level managers to pick from.

Higher prices can be bad news for buy-out firms, which typically want to acquire companies at a discount. Increased competition can be brutal for VCs trying to put its existing funds to work.

“We’re anxious as hell to get our money out and we’re committing to do four deals in 2005,” Morris said, adding that GKM put out five investment offers but didn’t close on any deals in 2004. “A lot of firms really turned up the pace of activity and we got skunked.”

Among the hottest sectors are information technology, health services and businesses that cater to homeland security. Telecommunications and enterprise software continue to lag.

Liquidity events

Kline Hawkes & Co. invested roughly $3 million in Rent.com, which had originally planned on going public, but chose instead to be purchased in a mostly stock transaction.

Frank Kline, managing partner at Kline Hawkes, is bullish for 2005 and said he expects 50 percent revenue growth on average in 2004 from the company’s 35 portfolio investments. The Kline Hawkes California L.P. fund, launched in 1995, has posted total returns of 41.6 percent.

“The attitudinal mindset has changed from the entrepreneur’s point of view,” he said. “Now, for the first time, we’re seeing people leaving the security of their jobs to launch early-stage start-up companies.”

But for every Rent.com or eHarmony there are far more difficult investments that VCs still need to escape. While some portfolio companies are turning a profit, they still may not be IPO or acquisition material despite five or six years of funding.

To attract new money, some of the deals required changes to so-called “liquidation preferences,” which give insiders the right to a specific value of stock if the business is liquidated.

Renee LaBran, a partner at Rustic Canyon Partners in Los Angeles, said funds that were formed in 1999-2000 are coming to the end of their investment cycle and looking for later-stage deals. “Two years ago you had VCs sitting on their money and hesitant to spend it,” she said. “This year, they’re feeling more optimistic, more willing to do A-round funding again.”