Business Analysis & Valuation

Chapter-1
Case Study: The Role of Capital Market
Intermediaries in the Dot-Com Crash of
2000 1
Objectives of the Case ?

To understand the role of key

intermediaries – venture capitalists,
investment banks, sell-side and buy-side
analysts, and professional money
managers, and public accountants – in
the functioning of capital markets.
 Observations from the case:

Problems arising out of information

asymmetries and incentive conflicts pose
important challenges for individual
investors who have savings to invest, and
entrepreneurs or managers who need
funds for pursuing business opportunities.

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Need for intermediaries

Financial intermediaries and information

intermediaries are invented to mitigate
these problems so that capital resources
of an economy are efficiently allocated to
best possible uses.
 Consequence of intermediaries

If you add up all the fees and income

earned by the various intermediaries in a
modern capital market such as the US,
the amounts are very large and
significant. Presumably, in a free market,
investors and managers will not expend
such resources unless they get value in
return.

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 Questions
(1) who are the intermediaries stated in
the case?
(2) the intended function of each,
(3) how each player is rewarded and
(4)what consequences of the compensation
function are ?
Venture Capitalists

Who? - Venture capitalists

Functions: Screen early stage investment
opportunities, and develop risky but
promising ventures through investment,
support and oversight
Reward: Rewards tied to returns at liquidation of
stake in public or M&A market.
Consequences of the compensation function:
Driven by the IPO market
 Investment Banks

Who? Investment Banks

Functions: Help companies raise capital in public
markets by underwriting and distributing
new issues.
Reward: Proportion of proceeds raised in the public
issue

Consequences of the compensation function:

Represent the interest of the seller,
rather than the buyer, of securities
 Sell Side Analysts
Who? Sell side analysts
Functions: Provide research reports and investment
recommendations to individual and
professional investors on new and existing
securities.
Reward: Rewards tied to accuracy of earnings
forecasts, and investment banking fees
generated.
Consequences of the compensation function:

Bias in favor of seller of securities to maintain

access to information, and to obtain
investment banking deals, and/or to generate
trading volume. Focus on short-term earnings
forecasts.

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 buy-side analysts

Who? buy-side analysts

Functions: Provide proprietary research reports and
recommendations to fund managers.

Reward: Rewards tied to earnings forecasts and short-

term stock return performance from
investment recommendations
Consequences of the compensation function:
Focus on forecasting short-term earnings
and short-term stock price.
 Professional money managers
(MF)
Who? Professional money managers
Functions: Buy and sell securities to earn superior
risk-adjusted returns

Reward: Paid as a function of the size of assets

under management, and relative
performance of the fund vs. a benchmark.
Consequences of the compensation function:
Focus on attracting new funds,
which are often driven by short-
term performance of the fund;
relative performance evaluation
potentially results in herd
behavior.
 Auditor

Who? Auditor
Functions: Enhance credibility of financial
information reported by the company, and
attest to its conformance with GAAP.

Reward: Rewarded for new client acquisition,

client retention, and generating non-audit
fees.
Consequences of the compensation
function: Unwillingness to confront the
client to increase the probability
of retention, and to attract non-
audit work.
Summary

 Intermediaries in the capital market

are invented to reduce agency and
information problems. However,
given the particular incentives these
players face, they do this job
imperfectly, at best. There is,
therefore, room for systematic biases
in their actions.
 Contribution of intermediaries to the
dot com bubble.

Venture capitalists
decided to fund many flawed ideas,
not necessarily because they
genuinely believed that they were
good ideas, but because they saw that
the stock market was valuing such
ideas highly.
 They could take companies public very soon after
they funded them (restrictions on the holding
period for private equity were relaxed in the
1990s).
Is this idea attractive to public markets in the short-term ?

They, and the entrepreneurs with their backing,

often pursued flawed business strategies,
putting growth and market share above profits.
Investment bankers
added to the problem by helping venture
capitalists and entrepreneurs take these
flawed ideas public. They were willing to
exploit a hot market based on the potential of
the internet to underwrite and market
businesses that were flawed at inflated prices.
They also rewarded sell-side analysts, who
worked for these banks, to write optimistic
reports justifying ever increasing stock prices.
Sell-side analysts were willing to go along with
this because their bonuses were dependent on
pleasing their investment banking colleagues.

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Buy-side analysts and money managers

bought stocks of flawed and unproven

businesses at inflated values for two reasons.
First, they would get preferential allocation of
IPO shares at attractive prices.

These shares were dumped on the first day of

trading to individual investors who were
eager to purchase them since they saw that
professionals were willing to buy these shares
as well.
Second, money managers were subject to herd
behavior given the performance incentives.

So even though they might have known that dot

com stocks were highly overvalued, they couldn’t
stop buying them for fear of being left behind by
their peers who might be willing to buy these
stocks and attract new funds.
 In fact, the experience of Janus funds which
grew dramatically during the late 1990s by
aggressively investing in internet stocks,
confirmed to many money managers the
attractiveness of such a strategy.

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Auditors
were reluctant to give going concern
exception to firms making huge losses and had
no foreseeable prospects for turning things
around. Their excuse was that these firms had
access to unlimited funds from the stock
market.
Why can not we blame individual investors
who were greedy and eager to go along with
the bubble?

The irony is that intermediaries are invented

in part because individual investors cannot
protect themselves.

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So why is it that the high-priced
intermediaries were so powerless to correct
the behavior of the individual investors?

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Ans: The recent “reforms” made professional
investors more responsive to the markets
than before.

Venture capitalists became more responsive as a

result of the elimination of restrictions on holding
periods.
Money managers because responsive to markets,
thanks to reduced trading costs for individual
investors both in funds and stocks

Auditors became response to markets because they

were subject to more competition as a result of
removal of professional restrictions on advertising
and competing for each other’s clients.

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What is the Consequence of
market responsive?

While each of these moves was well-

intentioned, they all had unintended
negative consequences, and weakened the
intermediaries. The net result is that they
were literally serving the whims of the
individual investors, rather than exercising
their professional judgments, which was their
intended function.

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What are the possible solutions ?

The broad approach has to be to make parties

involved a bit less sensitive to markets, and reward
them for performing their intended function.

For example, it might be a good idea to require

venture capitalists to hold on to their investments for
some minimum period, bear the early investment
risk, and bring their ventures to public markets only
when their value is reasonably established.

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It might be a good idea to increase transaction
costs for individual investors so that they
won’t be able to move around their pension
investments from one mutual fund to another
almost with costs. One way to do this would
be to have a graduated tax structure as a
function of the investment horizon.

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To increase auditors’ willingness to be truly
independent, one could consider several
remedies: (1) Restrict non-audit services
auditors can provide to their clients. This is
what the new laws passed by the Congress
after the bubble require. (2) Move the
responsibility of hiring and fixing audit fees to
the stock exchanges, and fund audits through a
tax on stock trades.

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Conclusion - Observations

First, intermediaries are not perfect, so

markets are unlikely to be perfect either.
This means that stock prices can deviate from
fundamentals. The dot com bubble is an
extreme example of it, but it happens less
dramatically but more frequently in individual
stocks.

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Second, intermediaries can perform their
function only if they are insulated from
market forces up to a point. This like saying
that democracy works only when you limit the
power of the popularly elected government.

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Assignment

Apply the case in Indian Capital Market

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Thank You

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