[Update 9/23/11: Remarkably, the firm has been put together again, albeit with fewer general partners. The firm’s limited partners stuck together, and have let three general partners continue to invest the firm’s funds. The partners are Salil Deshpande (the most prolific from the original group); Stu Phillips, formerly of USVP; and the firm’s former leader Neal Dempsey, although we’re told he is no longer leader. Indeed, the firm has quietly made several investments over the past year, including in Dynatrace, Engine Yard, Jambool, Buddy Media, Lending Club, Dropcam, ParAccel and others.]

Bay Partners, one of Silicon Valley’s oldest venture capital firms, is falling apart, highlighting the continued stress aging firms are facing as new realities hit the industry.

Three years ago, Bay Partners, a firm that launched in 1976, knew it was in trouble. At the time, we reported how the firm’s leaders orchestrated a clean-up, forcing several partners out, and hiring or promoting several younger, more promising partners to replace them.

But three of these newcomers — Eric Chin, Sandesh Patnam and Salil Deshpande — just resigned on March 23. Chin declined comment, saying he’d been advised by a lawyer not to. We could not reach Patnam or Deshpande before publication. This is a huge blow to the firm. The three comprised half of the six partners charged with investing the firm’s 11th fund, totaling $290 million, raised in 2005.

Gone are the comfortable days, when it was easy to place bets on Silicon Valley technology companies. Back then money came in short supply, and hungry startups gobbled up millions of dollars to build the emerging computer and Internet industries. The odds of returning a lucrative investment were pretty high, and the venture industry saw huge returns on average.

But lately, as the supply of money has outpaced quality startups able to absorb it, the average firm has performed poorly. Competition is winnowing the ranks. Older, larger firms, in particular, are struggling to hire experienced younger partners to carry the baton. At a time when most cool startups are building their products with much less money, many talented venture capitalists aren’t joining big firms anymore. They’re starting firms themselves.

In Bay’s case, its co-founder Neal Dempsey, who is mostly retired, told VentureBeat today that he will stay active and help the two other remaining partners, Atul Kapadia and Neil Sadaranganey, handle the board seats at portfolio companies being relinquished by those resigning. He said he had no idea why the three decided to leave.

“Wouldn’t they have told you why?” I asked Demsey.

“You’d think so,” he responded. “Anything I would say would be total speculation.” He said he’s had preliminary discussions “at best” with the three partners who departed, and is still trying to “sort things out.” Asked whether Dempsey and his remaining partners would be able to raise another fund after this split, he said “We’ll see, it’s never over until it’s over.”

Several of our sources say there’s more to this story. We’ll update this post as we gather more details.

Dempsey declined comment on the firm’s returns, saying its investment data is private. He also declined to give any examples of company success.

[Update: The firm’s 10th fund, raised in 2001, has a -10.1 percent internal rate of return (IRR) as of Sept. 2009, according to the California Public Employees’ Retirement System, which invested in the fund and makes its results public. The firm’s most recent fund, its 11th, shows a -14.6 percent IRR as of Sept. 2009, according to CalPERS.]

Aside from struggling to handle the generational turnover at his firm, Dempsey has been a controversial figure in other ways: He was on the board of Brocade Communications, and was hauled into court to testify during the trial of Brocade’s chief executive Gregory Reyes, who was found guilty of security and fraud charges related to the backdating of stock options. The board, including Dempsey, was eventually exonerated.

The outlook for Bay is dim across the board: Our sources confirm that a “key-man” clause has been triggered, allowing limited partners to withdraw their money from a fund in the event that major partners leave.

Investors in the existing fund include Paul Capital Partners, Horsley Bridge Partners, AlpInvest Partners, CS First Boston, BP Pension Fund, Portfolio Advisors and GIC Investments.

Some reports say Chin has started a new form called Portola Venture Partners, but there is no more information available about that yet.

It’s not as though the departing partners aren’t without their own share of success: Deshpande had invested in Springsource, a company that sold for $420 million to VMWare, Chin had invested in Invensence (he did so while at Artiman, the firm where Chin worked before joining Bay) and Interact 911, two companies rumored to be filing IPOs sometime in the next year or two, and Patnam has invested in two promising companies, Paraccel and EnPhase Energy.

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