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

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

1.Sanya Nauharia 2.Sankara Narayanan 3.Nikhil jha 4.Jay Saxena 5.Manju

The Role of Capital Market Intermediaries in the Dot-Com Crash of 2000 - Report Q1. What is the intended role of each of the institutions and intermediaries discussed in the case for the effective functioning of capital markets? Or List all the major players that play an intermediation role between individual investors and entrepreneurs/managers. What is the intended function of each of the intermediaries?

Ans. The institutions and intermediaries discussed in the case are: 1. 2. 3. 4. 5. 6. 7.

Venture Capitalists Investment Bank Underwriters Sell-Side Analysts Buy-Side Analysts Portfolio Managers FASB Accounting Firms (Auditors)

1. Venture Capitalists: VC’s has a role for screening a good business idea and entrepreneurial teams from bad ones. Partners at a VC firm work closely with their portfolio company to monitor and guide them to a point where the fully functional company can stand on its own i.e. they nurture the company until they reach a point where they are ready to face the scrutiny of the public capital markets after IPO.

2. Investment Bank Underwriters: Investment banks provide advisory financial services, help the firms price their offerings, underwrite the shares and introduce them to the investors. 3. Sell-Side Analysts: Their main function is to publish research on public companies. Their job involves forming relationships with and talking to managements of the companies, following trends in the industry and making buy or sell recommendations on the stocks based on the information gathered. Sell-side analysts interact with buy –side analysts and portfolio managers to market or “”sell” their ideas. They also provide support during a company’s IPO process by providing research to buy-side analysts before the company goes public. 4. Buy-Side Analysts: They are usually assigned to a group of companies within a certain industry and are responsible for doing industry research, talking to company’s management teams, coming up with earnings estimates, doing valuation analysis and rating the stock prices of the companies as either “buys” or ”sells”. They need to convince the portfolio managers within the company to follow their recommendations. 5. Portfolio managers: They are responsible for managing money. They are ultimately responsible for establishing an investment strategy, selecting appropriate investments and allocating each investment properly for a fundor asset-management vehicle. 6. FASB (Financial Accounting Standards Boards): To establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.

7. 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. Q2.How each of the intermediaries you identified is compensated for performing its respective function? Is the compensation arrangement likely to lead to any dysfunctional incentives? Ans: 1. Venture Capitalists The main income source for venture capitalists is a large chunk of a company profits, the compensation is directly proportional to the company performance. 2. Investment Bank Underwriters investment bank underwriters make commission on the funds a company manages to earn on securities offering. What happens after is of no big concern for investment bank underwriters since they have already made huge profit. Therefore, this would be the most misaligned incentive, on my view. 3. Sell-Side Analysts Sell-side analysts made their money from trading revenues they generated, as well as, from published rankings. In addition, some analysts received compensation from investment banking fees. From all of these incentives the latter has a potential to jeopardize analysts’ rankings and their “buy” or “sell” recommendations. 4. Buy-Side Analysts and Portfolio Managers The compensation incentives of buy-side analysts and portfolio managers are accordingly aligned with the interests of investors meaning that they make money when investors make money. The downside here is, as seen in Dot-Com Crash study, they could have recommended and bought stocks simply because they knew it would go up although at the same time they also knew that those stocks had been tremendously overvalued. 5. Accountants, Auditors and major auditing 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. Q3. Identify the role each intermediary might have played in the creation of the dot-com bubble. Was this behavior related to the potential dysfunctional behavior identified in question 2? Ans: 1. Venture Capitalists: VC’s had invested in many failed dot-com startups. They were unduly influenced by euphoria of the market and were ready to knowingly invest in companies with questionable business models that had not proven themselves operationally. This ready availability of funds influenced the behavior of management of new companies and thus encouraged them to go for market share. 2. Investment bank underwriters: The entrepreneurs rely on investment banks in the actual process of IPO. IB underwriters were involved in raising capital and provide expert advice on the investments to be made in these companies. These investment underwriters did not properly scrutinize and analyze the companies they invested in and were taken away with the market conditions of the new economy. They thus invested a lot of market capital in these new companies which could not be paid back by these dot-com companies as they were not making profits. 3. Sell-side analysts and portfolio managers: Sell-side analysts instead of focusing on the EPS and forecasting it to analyze the company’s performance were involved in forecasting of the share prices themselves. They lost track of the real variables to be considered for investments got carried away with the flow of market and thus provided information to buy-side analysts on the basis of the share prices of dot-com instead of EPS forecasts thus were not really able to distinguish the “good” and the “bad” companies which led to further over-valuation of these internet based firms. 4. Buy-side analysts: Buy-side analysts and portfolio managers invested heavily in the overvalued companies even though they knew that these internet firms were overvalued this further inflated the prices of dot-com company shares. This may be linked either to their incentives as well as the pressure from their competitors. 5. Accounting firms (Auditors): The accounting auditors did not adequately warn the investors about the precarious financial position of these companies and were not given the “on going concern”. This led to inadequate information to the investors which could raise concern among them about these companies being defaulters thus they were sure of their investment and paid for higher stock prices. 6. FASB (Regulator): There were ambiguous accounting principles these companies could leverage upon which helped them project their financial statements in their favor; thus providing subjective judgment by the accounting auditors and lack of clear and concise information in the market.

7. Retail Investors: There was an increase in the number of retail investors who began trading in their own and contributed up to 18% of the trading volume in NYSE. Many of these investors did not know about finance and valuations. The institutional money managers bought overvalued companies and sold them to these retail investors at even higher valuations. This lead to inflation in the prices of the dot-com companies and thus the dot-com bubble. Q4. Who, if anyone was primary responsible for internet stock bubble? Ans: The responsibility of the market bubble cannot be attributed any one institution or intermediary. It is a cascaded effect of the activities of all the entities in the capital market. The financial intermediaries were responsible for making decision not based on relevant financial variables and instead on the market reputation of the industry. They also were involved in supporting some companies which did not have strong business models. On the other hand the accounting auditors did not adequately warn the investors about the precarious financial position of these companies and were not given the “on going concern”. This led to inadequate information to the investors which could raise concern among them about these companies being defaulters thus they were sure of their investment and paid for higher stock prices. Also the informational intermediaries like the sell-side analysts and buy side analysts lost their focus from the fundamental analytical variables to the forecasts of share prices thus misleading the financial analysts. Thus this formed a cyclical model where none of the institution could foresee the market bubble being formed. Q5. What are the costs of such stock market bubble? As a future business professional, what lessons do you draw from the bubble? Ans: The cost associated with such a market bubble are: a. The valuable resources like employees who work at these failed companies could have spent their time and energy creating value in their endeavors. b. The capital that funded bad business ideas would have been plowed into viable, lasting companies that would have benefited the overall economy. c. Some of the genuine intermediaries suffer a loss of repute due to such market bubble. The confidence of the investors on these institutions is lost and thus impending a higher cost for the trust retrieval of these investors. d. These bubbles reduce the funds flow in the market for some duration leading to liquidity crunch in the economy. e. Decrease in the wealth of the citizens and thus dampening the consumer spending. f. Many firms that need to raise capital for investment may find capital markets shut to them. g. There is a threat to the economy to enter into a recession state.

The lessons learnt from the case are as follows: 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.

Q6.Summary/ lessons The case presents the genesis and the crash of the Dot-Com Industry in 2000 and the role played by various capital market intermediaries in the bursting of the DotCom bubble. During the late 90’s a host of IT consulting companies like Scient Corporation, Viant Corporation, IXL Enterprises etc. went public. The stocks of these companies reached astounding heights, for example, the stock of Scient witnessed a 1238 % increase and a valuation of 62 times the company’s revenues for fiscal year 2000 and other companies also performed similarly. They offered a value proposition in the new economic era in terms of expertise in information technology and web based services by capitalizing on the escalating demand for Internet expertise. New economy companies based their business model such that they could take advantage of the Internet and e-Commerce (Bricks and Clicks model) and there was a pressure on old economy companies (Bricks and Mortar model) to adopt technology based models in order to retain their market share. The Nasdaq Composite Index dominated by new economy companies rose by 74.4 % while the Dow Jones Industrial Average dominated by old economy companies fell by 7.7 %. Everyone wanted to own shares of high-tech companies. The prices of stocks of Web Consulting & Internet firms dropped suddenly in April 2000 after Nasdaq correction, however the prices stabilized for some period because of the buy ratings given by many analysts. It was difficult to foresee the sharp downfall in the stock price as situation worsened in September 2000 after some bad news from Viant Corporation and other stock downgrades from analysts resulting in more than 95 % decline from the peak valuations. The stock prices of these firms were now trading in single digits. The impact of such a debacle was far reaching as it led to a sharp fall in the consumer confidence thereby dampening consumer spending which along with slowing of U.S. economy signaled a state of recession for the U.S.

The key intermediaries in the investing chain were affected significantly and were in partially responsible for the bubble burst. The Venture Capitalists (VCs) provided capital in companies in early stages and prepared them Initial Public Offerings (IPOs) generating high rate of return for the investors and were questioned for knowingly investing in failed dotcoms. High stock market valuations and willingness and readily available capital affected the strategies and outlook of Internet companies leading to their downfall. Investment bank underwriters’ who provided investment advisory services were given a commission of around 7 % of the money the company manages to raise in its offerings so, naturally they grabbed enormous fees to the tune of $600 million. Sell-side analysts played an influential role in the stock market by providing their in-depth research to the buy-side and giving optimistic buy-ratings to Internet firms which were over-valued. The buy-side Analysts and portfolio managers came up with earnings estimates and valuation analysis for deciding on which stocks to buy and which ones to sell to improve the performance of their funds relative to an appropriate benchmark return thereby aligning their interests with those of the investors. The accountants and auditors who were supposed to provide an additional level of assurance of quality did not attempt to caution the investors about the bankruptcy, going concern clause and risky financial position of the companies and sustainability of the companies. Amid discrepancies by most of the intermediaries in the investing chain, such a crash was bound to happen in a scenario where sustainability of business was overlooked against high stock prices of a company leaving many investors broke. The lesson learnt from the Dot-Com debacle is that each intermediary should play their role honestly and do what is right instead of getting influenced by market conditions or incentives. Analysts and accountants should perform their role to perfection by providing correct facts and removing discrepancies which may result in wrong decisions. The investors on the other hand should learn the fundamental rule for investments in stock markets such as PE ratio, study market trends and reviewing business plans.