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: VCs 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
companys 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 companys 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: VCs 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 companys
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 its 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 90s 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 companys 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.