The Role of Capital Market Intermediaries in the Dot-Com Crash of 2000
Intended role of each institution/intermediary: Venture Capitalists – They screen companies with good business ideas from bad ones and provide capital to the start-ups with good business ideas. The required return on capital for VCs is very high to compensate the shareholders for the higher risk in investing in new businesses, and this is achieved when VCs sell their stake in the business through IPOs or trade sale. Thus, VCs will work to ensure the business is sound so that it will fetch the highest possible price when going public.
They provide advisory financial services, price the IPO, underwrite the shares as well as introduce the company to the public. They are then paid a commission fee based on the amount the company manages to raise in the IPO. Thus to maximize their fees, IBs are motivated to pick the best companies which the public will pay the most for. Sell-side Analysts – They provide support during IPO process by providing research to the buy-side before the company goes public. They also publish research on public companies and make recommendations on the stock, which could be very influential on investors.
They are compensated based on amount of trading fees and IB revenue generated through their research. Buy-side Analysts/Portfolio Managers – These are institutions that actually buy or sell public stocks. The analysts research the companies and provide recommendations to the portfolio managers. Compensation for the analysts is based on how good are their recommendations. Portfolio managers act on behalf of investors and will buy the actual stocks based on the analysts’ recommendations and their own judgment.
Their compensation is determined by the performance of their portfolio compared to the benchmark return. Accountants – They audit the financial statements of companies, ensuring that companies’ financials reflect the true state of the firm and are also in compliance with established standards. Investors rely on the opinions of the auditors and the auditors receive audit fees from the companies they audit as compensation. 2. The incentives for VCs, and Buy-side Analysts/Portfolio Managers are aligned with their roles.
However, some of the incentives of the institutions and intermediaries are not properly aligned with their intended role, such as IBs, Sell-side Analysts and Accountants. IBs and Sell-side Analysts are motivated to price the IPO as high as possible as their compensation is based on the amount the IPO is able to raise, so they could potentially over price the IPO intentionally and are also subject to optimistic bias. Accountants are supposed to verify the accuracy of companies’ financial statements but they are also paid by those same companies.
In order to keep their clients, accountants may be motivated to audit the company in such a way that caters to the companies’ expectations rather than according to established standards. 3. Each institution and intermediary from the VCs to the retail investor has played a part in contributing to the Internet stock bubble. It was the combined over-optimism of the IBs and Analysts and the investors who listened to them which created the stock bubble. In my opinion, the IBs and Sell-side Analysts are the most to blame.
It began with their overvaluation of companies during the IPO offering which were unsustainable and they continued to issue buy recommendations even when stock prices were going down, knowing that investors will follow their advice. Investors on the other hand also played the momentum game and listened to the analysts’ recommendations without researching to understand the companies they are investing in. 4. The cost of a stock bubble is extremely high could affect the entire economy. Companies and investors are the ones who lose the most in a stock bubble.
Once the bubble bursts, companies will find that equity markets are closed to them and if they are operating at losses and strapped for cash, they will quickly close down. Investors also suffer the consequences of a stock bubble, often ending up empty handed when the companies they invested in go bust. Losing money, consumer confidence will fall and decrease in wealth will dampen consumer spending. This could potentially put an economy into recession. Stock bubbles are also a waste of resources, as resources ploughed into them could have been used for other, more sustainable ndeavors.
As an investor, the lessons I learnt from the bubble is to always do my own, comprehensive research before investing in any companies, no matter how aggressive or optimistic the market sentiment is at the time. As an IB or analyst, prudence should be observed when issuing recommendations, and the ultimate goal of my job should be to price a company stock as fairly as possible. Finally, as an accountant, any audits must closely follow accounting standards, and going concern clauses should be added whenever needed.