The Dot Com Crash Essay
1.What is the intended role of each of the institutions and intermediaries discussed in the case for the effective functioning of capital markets? Broadly, the institutions and intermediaries’ primary role involves channeling investors’ savings and funds to new companies that require capital to finance and grow their businesses. Because there is an information gap between investors and companies, investors rely on intermediaries to act as the experts on these investments in which intermediaries provide advice and recommendations. The specific role of each intermediary are as follows:
Venture capitalists: Provide capital for companies in early stages of development. VC firms source capital from institutions and high networth individuals. Investment bank underwriters: Provide underwriting and IPO services for companies going public. They facilitate a company in gaining capital from the capital market Sell-side analyst: Analysts for investment banks and brokerage houses that researches on stocks and makes recommendations on its value whether to buy or sell. Portfolio managers and buy-side analysts: Analysts and managers that makes actual purchases on stocks on behalf of the mutual funds, hedge funds, or insurance companies that they are managing. The capital from these funds are sourced to buy stocks. Accountants: Provides audit and assurance services on companies’ financial statement to satisfy the regulatory requirement.
2.Are their incentives aligned properly with their intended role? Whose incentives are most misaligned? Not all intermediaries’ incentives are aligned properly with their intended role. Some intermediaries such as buy-side analysts and portfolio managers are pressured to buy an overvalued and increasing stock by its investors although knowing the fundamentals of the business are not strong and the stocks overvalued. Investment banker fees are usually paid based on a percentage of the funds raised from IPOs therefore they are incentivized to make as many IPOs as possible although some companies are still posting profit losses.
Sell-side analysts who work for investment banks are also at fault because they are pressured to make buy recommendations to reap a portion of the share trades that would result from a buy transaction and overall market positivity in dot com shares. Venture capitalists were also blamed to take technology companies public too early. Companies averaged 5.4 years in age when they went public in 1999, compared with 8 years in 1995. However, sell-side analysts and investment bankers incentives were most misaligned because they only assist in the deal-making process and their fees are paid regardless of the companies going bust in a couple of years.
3.Who, if anyone, was primarily responsible for the Internet stock bubble? There was not a single party that was primarily responsible for the dot-com stock bubble. It was however the result of a combination of parties that rode the momentum of increasing market confidence in new technology companies and also an increasing readily available capital market. Management of companies themselves were to blame as they did not focus on operating effectively and gaining a sustainable competitive advantage but instead relied on external capital to finance the companies’ ongoing operations.
Over-confidence of the technology market combined with readily available capital accelerated the rise of these companies which then diverted management focus away from operations to obtaining more external financing. This was exemplified in the text when one MD said ‘it was able to do a secondary offering at a high price and now had lots of cash on its balance sheet’. He further states his view that ‘it could boil down to the company with the best balance sheet wins’.
4.What are the costs of such a stock market bubble? As a future business professional, what lessons do you draw from the bubble? On an economic perspective, the consequences of a stock market bubble are recessions, drop in market confidence, unemployment and an overall weaker economy. As large amounts of capital disappear due to failing companies, overall wealth in the economy decreases which can cause a recession. Socially, stock market bubbles can create problems like increasing suicide rates and other crimes due to large losses of wealth. Lessons that can be learnt from the bubble are companies that are overvalued needs to be thoroughly examined to ensure the company has good fundamentals which include management having a sound business model with several revenue streams and good long-term strategy.