The following financial intermediaries’ activities led to the dysfunctional incentives, causing the crash in 2000:
- Venture capitalists: Most of them were highly influenced by the euphoria of the market and knowingly brought public companies with questionable business models, or that had not yet started giving potential results. Many of the dot-coms went public with in record time of receiving VC funding, companies with average life of 5.4 years when they went public in 1999, compared to 8 years in 1995. Because of high stock market valuations, VC firms invested in companies during late 1990s that they would not have invested in ordinary situation.
- Investment bank underwriters: Investment banks went ahead to help under-performing companies to go public. They charged high fees, a total of more than $600 million directly related to IPOs involving the companies whose stocks came down to $1.
- Sell side analysts: Instead of forecasting EPS, they started forecasting share prices. And those tend to be very optimistic. Some analysts were put out by recommendations throughout the scenario. While making stock recommendations, analysts were highly influenced by the possibility of banking deals. Significant amount of analyst’s income included fees from trading revenues and from publishing the rankings.
- Buy side analysts and portfolio managers: Analysts at the firm began to recommend the over-valued companies simply based on their assumption that the stock prices would go up. It developed the sense of fear among portfolio managers that if they didn’t buy the stocks, they would lag their benchmarks and their competitors, as they used to compare against their peers for marketing purpose.
The following steps could be taken to tackle the problems associated with financial intermediaries:
- Venture Capitalists should do their best to make sure that the companies they invest in should have good management team and a sustainable business model that can stand the tough times.
- Investment bankers are expected to use their expertise and knowledge, apart from just helping companies to go public, they should also advise companies about the timing and the consequences of going public.
- Portfolio managers acting on behalf of investors must only buy fairly priced stocks and should sell them if they become overvalued, as buying or holding an overvalued stock will ultimately result in loss.
- Sell side analysts, whose clients include portfolio managers and hence investors, should objectively monitor the performance of public companies and determine whether or not their stocks are good or bad investments at any point in time.
- Accountants must audit the financial statements of companies, with due diligence to ensure that they comply with the established standards and represent true state of the firms. This give investors and analysts the confidence to make decisions based on these financial reports.
Submitted By-
Neha Rusia
PRN- 15020841088