Beatriz Mena- The Dot-Com Crash Case

How market works in general, we have two groups, the investors

(which have savings and wish to apply this money in a business and
get high return) and the companies (which need the money for
create new products and make profit). We have two problems:
(1)Information asymmetric: entrepreneurs know more the firm
value than the investors/ Information friction: what company
should I invest?
(2)Agency problems: they should maximize the share holds
wealth however managers can maximize their own utility
Two groups: financial intermediaries (VC/ IB/ Fund Managers)
getting money from investors + information: verify and
analyze the information provided by open companies (there is
risk of fraud).
Most of times they are working properly, however sometimes
they are in problem as in the dot-com crash of early 2000s.
1. What is the intended role of each of the institutions and
intermediaries in the case for the effective functioning of
capital markets?
In the economy, households and institutions seek good
investment opportunities for apply their savings. On the other
hand, there are several entrepreneurs and existing companies
that would like to attract these savings to fund their business
ideas. Once thaut the markets are not perfect, financial and
information intermediaries are crucial in order to connect
these two agents. In the case, the author highlights the role of
several intermediaries and institutions on the context of the
Dot-Com Crash:
a) Venture capitalists are responsible for provide capital to
the firms when they are still small, in other words, in their
early stages of development. Doing so, the VC can earn a
huge return if the business becomes a success, therefore a
good VC should be able to screen good ideas from bad
ones. On the bubble context, the VC invested in companies
in the late 1990s because of the high stock market
valuations, in ordinary circumstances they would not
invested as much as they did. Get capital from private
investors and make the company grow and then sail to the
market sell the company, make a success IPO not a long
term perform of the business. People intend to buy as
company as they can (dont miss the new microssoft)
b) Investment bank underwriters are the agents who are
in charge of doing an Initial Public Offer (IPO), as part of the
process, the investment banks help the firm calculate the
price of their offering, introduce them to investors etc. As
the bank receive a commission based on the amount of

money that the company raised with the offering, it has

incentive to overprice once that the market was buying this
shares anyway. Sell shares to the general market, so you
have to focus in good companies because the share price
should be stable. But now they were getting as much
company as possible because they earn fees as they were
gaining fees anyway.
c) Sell side analysts publish research on public companies
which consider trends of the industry and specific practices
of the firm. Usually those reports contain a by or sell
recommendation as well. On the crash context, several
analysts were target of criticism as they give a buy
recommendation for companies whose stocks had dropped
steeply a few months after.
Fund Managers take the money in order to invest n good
projects and then can make profit. In dot-com they were
buying and selling because the general buyers were always
pushing the price up, so they were magnifying the bubble.
They did that because they performance is measured by
comparison, so they couldnt have a underperformance
over and over and its impossible get the same profit as the
dot-com firms.
d) Buy side analysis is performed by institutions which do
the actual buying and selling of the securities as mutual
fund companies, hedge funds and insurance companies. A
buy-side analyst is responsible for doing an industry
research and then decide whether buy the stock or not. The
analyst has also to convince the portfolio managers within
their company to follow their recommendation.
The
portfolio managers as the name say, manage the money,
they listen to the analyst recommendation and then take
the decision. In early 2000, many analysts knew that
several Internet companies were overvaluated, but they
felt pressure to invest (they new that in the short time the
prices are going up).
Financial
Analysts:
forecast earnings. What their
incentives? Work hard and make sure you recommendation
will make money to your customers. As they worked for the
IB, they can have positive bias because their bank is
underwriting shares of these companies. Sometimes they
work for brokers, so they could get commission, buy
recommendation would help their brokers for buying. They
are pressured to be accurate (you have to have some
relationship with the mangers, so they were helping their
friends)
e) Accounting Profession, their job is audit financial
information provided by public companies in order to
prevent fraud, if there is something wrong, they can warn

investors about the financial position of some firms.

Whoever, in the dot-com scenario the auditors didnt gave
going concern clauses to firms in poor conditions.
Make sure that the numbers are consistent with the
accounting standards, so you have to be independent.
Small companies did the audition not the five big ones.
f) Regulator, which is the Financial Accounting Standards
Boards (FASB) in the USA, has the mission to establish and
improve standards of financial accounting and reporting for
the guidance and education of the public. In fact, with the
emerging of new economy firms (firms that deals with
Internet as consultants and dot-coms) some assets became
difficult to measure as well as some accounting rules became
obsolete.
2. Are their incentives aligned properly with their intended roles?
Whose are most misaligned?
The incentives are not aligned properly why their
intended roles, as the main incentive is earn profit while the
role is to become an information channel in which people can
rely on in order to take investment decisions. The main
problem is that sometimes making a good information role
doesnt guarantee a high profit. For example, Investment
Banks dont have incentive to offer a stock at a faire price, but
the one that will maximize their own revenue.
In my opinion the most misaligned agent is the Venture
Capitalists because in the late 1990s they were giving money
to firms that were going public too fast, so they didnt need to
bet in a sustainable business, only a firm easy to sell later with
high profits.
Investors were pushing the prices so high that cause the
distortion.
3. Who, is anyone, was a primarily responsible for the Internet
Stock Bubble?
I dont think that there is a primary responsible for the
Internet Stock Bubble, because as described on the case,
several agents had incentives misaligned and didnt play their
roles properly.
The venture capitalists were investing in firms that were
going public right away, so as the investors were waiting for
the next big thing, the stock price would valorize. Also the
sell-side analysts didnt give proper recommendations, as
their suggestion were always optimists. Moreover, the buyside even knowing that the stock prices were overvaluated,

they invested on them anyway. Even the auditors arent

exempt of fault, because they didnt warn the investor about
the poor financial condition of the firms.
4. What are the costs of such a stock market bubble? As a future
business professional, what lessons do you draw from the
bubble?
Bubbles are harmful to the economy because they can destroy
a large amount of wealth as they allocate resources in bad
projects. Moreover bubbles can lead negative impacts in the
confidence in overall economy that can take a while to
recover.
I think that the main lesson that we can take from a bubble is
to be aware with extremely rapid growth, because probably
this pace cant be sustained in a long term and its an
indicative of bubble behavior. Moreover, we need to analyze if
a business can generate income with its own activity or if the
valorization is due only to speculation.