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

Business Analysis and Valuation Assignment 1 - The Role of Capital Market Intermediaries in the Dot-Com Crash of 2000 Group Members: 1. 2. 3. 4. 5.

Prateek Jain – 2011A2PS501P Sahil Dumir – 2011B3A1612P Devesh Gupta – 2011A4PS260P Aniruddh Mishra - 2011B3C7585P Ankit Rao Shivaprasad - 2011B3A1374P

Ans1. The following entities perform the function of intermediation between individual investors and entrepreneurs/managers: 1. Venture Capitalists: The function of Venture capitalists is to provide capital for companies in their early stages of development and screen good business ideas and entrepreneurial teams from bad ones. It employs business savvy people who worked closely with their portfolio companies to both monitor and guide them to a point where they have turned a business idea into a well-managed fully functional company that could stand on its own and nurture the companies until they reached a point where they were ready to face the scrutiny of the public capital markets after an IPO. Examples include Axiom Ventures, Seqoia Captial, Bain Capital Ventures. 2. Investment Bank Underwriters: Investment banks provide their expertise to companies to go public or make subsequent public offerings and introduce them to investors. They provide advisory financial services, help companies price their offerings and also underwrite the shares. Examples include Goldman Sachs, Merrill Lynch and Morgan Stanley. 3. Sell-Side Analysts: Sell side analysts publish research on public companies. They provide their ideas to buy side analysts, portfolio managers and money management companies by talking to the managements of the companies, following trends in the industry and making buy or sell recommendations on the stocks. 4. Buy-Side Analysts: A buy-side analyst performs industry research, talks to the companies' management teams, provides earnings estimates, does valuation analysis and rates the stock prices of the companies as ‘sells’ or ‘buys’. Buy-side research is not published but a buy-side analyst has to convince portfolio managers in the company to follow his recommendations. 5. Portfolio Managers: A portfolio manager either makes investment decisions using money other people have placed under his control(investor side) or manages a firm's money, say a retail mutual fund or an institutional account(investment side). He is responsible for buying or selling securities.

Portfolio managers make decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance. 6. Accounting Firms: The accounting auditors have the responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. They have the responsibility to express an opinion on the company's financial statements. They also assess the effectiveness of a company's internal control over financial reporting – the process designed and implemented by the company's management to address the risk of material errors and misstatements in financial statements.

Ans.2 Different intermediaries have different ways of compensating for there performance. The way of compensation for intermediaries identified above is as follows-: 1) Venture Capitalists: Their main form of compensation was a large share of profits (typically 20%) in addition to relatively low fee based on the assets under management. Yes the compensation arrangement is likely to lead to dysfunctional activities, as the fee is relatively low compared to the 20% which they get if the company makes profit. As happened for internet companies, VC were being influenced by euphoria of market and they knowingly invested and brought companies public with questionable motives just to earn larger profits. 2) Investment bank underwriters: Investment banks were paid commission based on amount of money that the company manages to raise in its offering, typically on the order of 7 percent. Yes, the commission arrangement is definitely going to lead to dysfunctional incentives to maximise the profits, as they would be tempted to help more companies, even those that are not ready, to go public. 3) Sell-side analysts: Sell-side analysts were partly compensated based on amount of trading fees and investment banking revenue they helped the firm to generate through their research. Yes, the compensation arrangement may lead to dysfunctional incentives as analysts may publish wrong results and show opposite ratings, e.g. (publish buy share though results suggest selling) in order for company to generate profits so that they can earn more. 4) Buy-side analysts and portfolio managers: The compensation of buy side analyst was often linked to how well there stock recommendations did in market, while in case of portfolio managers compensation was determined by performance of there funds relative to an appropriate benchmark return. These compensation schemes aligned the incentive of buy-side analysts and portfolio managers with interest of investors. As the interests of investors and buy side analysts and portfolio managers align together thus the compensation arrangement here is less likely to lead to dysfunctional incentives.

5) Accounting Firms: Accountants and auditors charge fees for the work they perform. These fees do not directly depend on what kind of opinion is issued and on how well the company being audited is doing. Investors rely heavily on auditors’ opinion while making their investment decisions especially on opinions of audit firms that have good reputation for long time.

Ans 3 The roles played by each of the intermediaries in the dot-com bubble is listed as follows: 1. Venture capitalists: They were highly influenced by the euphoria of the market and knowingly investing in and bringing public companies with questionable business models, or that had not yet proven themselves operationally. Many of the dot-coms went public with in record time of receiving VC funding, companies averaged 5.4 years in age when they went public in 1999, compared with 8 years in 1995. Public market had a tremendous impact on the way VCs invested during the late 1990s. Because of high stock market valuations, VC firms invested in companies during late 1990s that they would not have invested in ordinary circumstances. 2. Investment bank underwriters: Investment banks took underperforming companies public. They bagged enormous fees, a total of more than $600 million directly related to IPOs involving just the companies whose stocks came down to $1. 3. Sell side analysts: Instead of forecasting earnings per share, they started forecasting share prices themselves. And those prices were almost always very optimistic. High-flying stocks that a year before were going to be cheap at twice the price valued had halved or worse. Some analysts were put out by recommendations all the way down. Analysts were highly influenced by the possibility of banking deals when making stock recommendations. Analysts also got significant fees from the trading revenue they generated and from the published rankings. 4. Buy side analysts and portfolio managers: Analysts at the firm began to recommend companies simply because they knew that the stock prices would go up, even though they were clearly overvalued. Portfolio managers felt that if they didn’t buy the stocks, they would lag their benchmarks and their competitors. They compare against the performance of their peers for marketing purposes.

Ans 4. As far as the role of intermediaries is concerned, the following steps could be taken to fix the problems:

 Venture Capitalists should do their best to ensure the companies they invest in have good management teams and a sustainable business model that will stand the test of time.  Investment bankers are expected to use their expertise, and apart from simply helping companies to go public, they should also advise companies about whether they are ready go to public or not  Portfolio managers acting on behalf of investors must buy only those companies’ shares that are fairly priced, and should sell them if they become overvalued, since buying or holding an overvalued stock will inevitably result in loss.  Sell side analysts, whose clients include portfolio managers and hence investors, should objectively monitor the performance of public companies and determine whether or not their stocks are good or bad investments at any point in time.  Accountants must audit the financial statements of companies, ensuring that they comply with established standards and represent true state of the firms. This give investors and analysts the confidence to make decisions based on these financial documents. The integrity of this process is critical in an economy because it gives investors the confidence they need, to invest their money into the system.

Ans 5. Summary and Lessons The Bubble This case talks about the various players and intermediaries who had a role to play in the famous dot-com bubble crash of the year 2000. A combination of rapidly increasing stock prices, market confidence that the companies would turn future profits, individual speculation in stocks, and widely available venture capital created an environment in which many investors were willing to overlook traditional metrics such as P/E ratio in favor of confidence in technological advancements. Intermediaries In any business the intermediaries play an important role. The availability of correct information is important and very critical. Any wrong information can lead to wrong investments and tank the confidence of investors. Without this confidence, they would not make any further investments and put money back into the market. Lessons and Reasons for the crash 1. Going Public too early: The companies released their IPOs at a very early stage. This led to a belief that companies were doing very well and people started to invest in them. 2. Faults of Intermediaries: The financial intermediaries kept a blind eye towards the overvaluation of

newly emerged internet companies’ stocks, leading the investors to make huge investments in the dot-com companies, who were unaware about the unsustainable business models. 3. Overlooking profitability: Companies were striving for large customer base that was needed to cover the high fixed cost. So, profitability became a secondary concern and companies went public without any positive earnings making them top operate at losses which gave rise to a period of irrational exuberance and evolution of classic stock market bubble. Aftermath The dot-com bubble not only caused huge losses to investors but also used up valuable resources that could have been more efficiently allocated within the economy. The people who worked at failed internet companies could have spent their time and energy creating lasting value in other endeavours. Many companies that needed to raise capital for investment found the capital markets shut to them, leaving the market only with bad players. Lessons learnt 1. Popularity does not equals profits i.e. many firms that are popular at a given point of time does not mean they are worth investing in. Focus should be on the business fundaments that are being followed by a particular company. 2. Never invest in a company based solely on the hopes of what might happen unless it’s backed by real numbers. 3. A company without a sound business model should not be invested in. 4. When determining whether to invest in a company there are financial variables that must be examined like dividends payout, sales forecasts, profit margin etc.