The Role of Capital Market Intermediaries in the Dot-Com Crash of 2000 - Case Study Example

CASE Study: The Role of Capital Market Intermediaries in the Dot-Com Crash of 2000 CASE Study: The Role of Capital Market Intermediaries in the Dot-Com Crash of 2000 From the case, there are a number of players who play the role of intermediation between individual investors and managers or entrepreneurs. They include the lawyers, accountants, regulatory bodies such as the SEC in the United States, venture capitalists, investment banks, money management firms, as well as the media. All these players possess specific roles that they play to enable a complete form of intermediation between the individual investors, the managers and other entrepreneurs. Therefore, they possess intended functions. For instance, the venture capitalists typically make demands for higher returns on investments. The players usually leave the portfolio companies in the form of IPOs and ensure that the companies have perfect management teams and business models that are sustainable and can stand the test of time. However, the companies will be considered to have a lower value in case they attempt to go back to the public. In general, the players were tasked with ensuring that the companies were well nurtured and became ready to be scrutinized by the public capital market after an IPO. Investment bankers will also apply their expertise in assisting the companies to go public or to make consequent. As such, they introduce the firms to the investors. The Investment banks did this by providing advisory, financial services and they helped the companies price their offerings and underwrite the shares. It was often done in the form of a road show. On the other hand, the portfolio managers also have the special role of acting on behalf of the investors. They are expected to help them buy companies that are fairly priced. This is achieved through selling companies that have become overvalued because buying or holding onto an overvalued stock will directly lead to a great loss. Sell side analysts have their own clients who include portfolio managers. Their main roles included the publishing of research belonging to public companies. As such, investors will monitor the performance of public companies objectively. This will help them to determine the suitability of the stocks as a form of investment at any particular point. Buy side analysts possess some roles similar to those of the sell side analysts. They were assigned to a particular company to conduct company research. Accountants are faced with the task of auditing the financial statements of the companies. They make sure that these companies comply with standards that have been laid down. Therefore, they act as real representatives of the true status of the firms. It provides the analysts and the investors with the confidence to make various decisions based on the present financial documents (Buckman, 2001). In return, each of the intermediaries identified above is compensated for performing their respective functions. Venture capitalists were largely compensated by getting a large share of profits. Typically, they got about 20%. In addition to this, they were given a relatively low fee that is based on the assets they had under management. Yes, the compensation arrangement is likely to lead to any dysfunctional incentives. This is because the Venture capitalists will invest in numerous companies than usual. The investment banks were offered commissions which depended on the amount that the company was able to raise as its offering. They contributed to the dot com bubble by involving a number of blue chip companies in raising the capital process of the internet consultants. In turn, they led to a dysfunctional incentive where most of the companies filed for bankruptcy. Yes, this behavior was associated with the dysfunctional incentive since the capital had to be raised. Sell side analysts were compensated in accordance to their ability to help the firm generate more revenue through research. They were therefore, usually compensated on a partly basis on the grounds of the amount of trading fees and the revenue from the investment banking (Palepu, 2006). However, it resulted to certain dysfunctional incentives where the stocks were downgraded by some well-respected analysts. This caused a severe and swift response from the market, which led to the decrease of stocks on the same day. They contributed to the creation of the dot com bubble since they bought ratings from companies that, subsequently, had a great fall in their prices. They were responsible for the blame placed in relation to the recommendations of the tech stocks. These problems can be avoided by performing a thorough analysis and making a proper forecast on the earnings per share. Additionally, it is vital to show the stock recommendations made by analysts. Each of the groups of intermediaries played a crucial role in the creation of the dot-com bubble. The venture capitalists were highly blamed for having been influenced by euphoria in the market in an unduly manner. In addition, they knowingly invested in the public companies and bringing in those with questionable models. Come of these included those that had not been proven to be operational. Yes, this behavior was related in the sense that most companies went public (Maremont & Hechinger, 2001). The compensation of portfolio managers was determined by the way their funds performed in relation to the appropriate return on the benchmarks (Palepu, 2006). The compensation that was provided to the buy side analysts was linked to the proper way with which their stock was able to perform in the recommendations. In both the cases of the portfolio managers and the buy side analysts, the compensations were meant to align the incentives of both groups to that of the interests of the investors. They are likely to result in dysfunctional incentives because more companies will invest with the hope that stock prices will go up despite their clear overvalue. This would make the internet companies to blow up hence a need for valuation. Before the dot com bubble, most of the buy side firms believed that the companies were worth trading for. Both the portfolio managers and the sell side analysts contributed to the dot com bubble since they continued to invest in internet companies that were overvalued despite the possession of this knowledge (Palepu, 2006). > 4. Most of these problems are fixed through proper decision making in case a company lacks profitability, and a good track record but sees liquidity. The other solution to these problems involve a closer analysis and scrutiny of the company. It is not wise to invest in a company for other reasons especially when it has been undervalued. There should be no pressure to invest in any company whatsoever. It is also important to have several influential recommendations made by the analysts. References Buckman, R. (2001). “Investors, Entrepreneurs All Play the Blame Game,” The Wall Street Journal, March 5. Maremont, M., & Hechinger, J. (2001). “If Only You’d Sold Some Stock Earlier—Say $100 Million Worth,” The Wall Street Journal, March, 22. Palepu, K. (2006). The Role of Capital Market Intermediaries in the Dot-Com Crash of 2000. REV, December. Read More