1)What is the intended role of each of the institutions and intermediaries discussed in the case for the effective functioning of capital markets? Overall the role of intermediaries is to close the information gap between investors and companies. Investors usually do not have enough information or expertise to determine the good investments from the bad ones. And companies do not usually have the infrastructure and know-how to directly receive capital from investors. Therefore, both parties rely on intermediaries to help them make these decisions. Other institutions like regulatory or lawyers are entities to ensure that the parties play by the rule and also to build and develop a framework of rules. Roles of important intermediaries in greater detail:
Venture Capitalists: Venture capitalists provide capital for companies in their early stages of development. Their role is to nurture the companies until they reached a point where they were ready to face the scrutiny of the public capital markets after an IPO. Investment Bank underwriters: help start-ups or young entrepreneurs to “go public”. Their role is to plan and organise IPO’s. Sell-side analysts: Their role is to collect information on public companies and then publish this information together with recommendations to the public/investors. Buy-side analysts and portfolio managers: very similar role as the sell-side analysts with the slight difference that they do not publish their research to the public but have to convince their portfolio managers to follow their recommendations. Portfolio managers are in charge of buying and selling securities based on buy-side recommendations.
2)Are their incentives aligned properly with their intended role? Whose incentives are most misaligned? To answer this question we will look at the incentives of the 4 intermediaries described in the case: VC’s: Their main focus lies on supporting a start-up with knowledge and try to make it grow until it eventually my go public. The compensation comes from a large share of profits as well as a large amount of money if the company can be sold well at an IPO. It is of great interest for VC’s to do it’s best to help the company grow and build a sustainable business model. Therefore it can be said that incentives and intended role are aligned properly. Investment Bank underwriters: their earnings are commission based on the amount that they are able to raise at the organised IPO.
The better the Investment Bank is able to attract potential investors, the higher are their earnings. In order to attract investors they help the companies to figure out the right offering prices, they do the actual underwriting and they introduce the companies to the investors in the form of road shows. As a result we think that their intended role and incentives are quite low aligned as Investment Banks, once the IPO is concluded, have no risk at all and are not depending on the company’s performance. They make huge amounts by organising the IPO’s but are not responsible for anything that happens to the company after the IPO.
Therefore our team would argue that these incentives are the most misaligned. Sell-side analysts: As mentioned above, their role is to give recommendation to investors based on thorough research. One incentive may be to build up a good reputation and become a well-respected analyst. However, since their compensation is based on the amount of trading fees and investment bank revenue which they help the firm to generate trough their research they are highly prone to tweak some of their recommendation in a favourable direction. Incentives and role are therefore only moderately aligned. Buy-side analysts and portfolio managers:
Buy-side is compensated on how well their recommended stock performs. Portfolio managers are compensated based on the performance of their fund plus an adequate benchmark return. In both cases their role performance influences the compensation amount and therefore it can be said that intended role and incentives are very well aligned. 3)Who, if anyone, was primarily responsible for this internet stock bubble? If the questions emphasis is on “primarily responsible” than one could argue that it is the VC’s fault as they invested in many questionable business models and brought them to the market very early in comparison to IPO’s of 1995 (5,4 years in 1999 to 8 years in 1999).
But also the Investment Banks can be blamed for the internet stock bubble. Those where the one’s how brought all these companies to the market in the first place. One could argue that it is their job to scrutinize potential IPO’s in order to come up with attractive companies for their investors to invest in. But as mentioned above, trough the huge misalignment between role and incentives Investment Banks focused more on getting as much IPO’s trough as possible.
4)What are the costs of such a stock market bubble? As a future business professional, what lessons do you draw from the bubble? Costs: There are costs for young entrepreneurs and start-ups who invest their own capital in the first place. VC’s help them grow, even though their business model might not be sustainable. There are also huge costs for all the investors how invest their money into questionable business models. Furthermore, the whole economy is affected. In the booming times the dot.com companies had hired many employees. After the burst of the bubble many people lost their jobs which brought the unemployment rate up and thus economic growth slows down. Other costs are the sunk costs i.e lost money that was invested in busted dot.com-companies that could have been invested somewhere else.
As a future business professional our lesson learned is to be more cautious about the incentives of the institutions and people one conduct business with. Always ask yourself “why is the other party doing this and where is their profit based on”? As Marc Cuban once said “Don’t blindly trust recommendations from people who are not affected by the outcome.” Furthermore, as mentioned in the case, many investors invested into businesses where they didn’t even know anything about the underlying business model. They relied solely on recommendations of third parties and their own believe in the overall concept of a dot.com company. Crucial is to have a basic understanding of the company you invest in, know the business model and know what factors it is dependent from.