simple case study

Direction_casestudy.docx

Direction

Please read case study pdf and answer the following questions. [do so within 1-page, answers’ combined length must be as least one page]

Notes: You should only use the information provided in the case (and public knowledge of Finance, meaning generally what you learn in class) for this case project. The reason is that managers are often given a limited amount of information, and they have to figure out what's best for their company given that limited information. You are assuming the position of a manager as you work on this case at the time at which the case occurred. For example, since this case is from several years ago, you should not use information from year 2017, since that would be the future from the standpoint of the case. You are supposed to try to predict what happens in the future, but actually checking what happened since the case took place defeats the purpose of being in the position in which actual managers are, which is a large part of what I am testing you on for this project. Basically, only use the information in the case (and general Finance knowledge), and stay in the time frame of the case.

1) Identify all of the major players that play an intermediation role between individual investors and entrepreneurs/managers. What is the intended function of each of these intermediaries?

The role of intermediaries is to fill the information gap between investors and entrepreneurs. Investors often do not have the expertise to analyze the fundamentals of a particular company or sector and entrepreneurs or companies do not have the ability to raise capital on their own. Intermediaries provide the necessary link between the two groups often making a nice profit of their own. The intended functions of these major intermediaries in this case include:  

Venture Capitalists - To monitor and guide companies to turn good business ideas into a well-managed, fully functional company that could stand on its own; 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 - To assist in the process of doing an IPO aka “going public.” Investment banks also provide advisory financial services for the companies, help them price their IPOs, underwrite the shares and introduce them to investors.

Sell-Side Analysts - To publish research on public companies and give support during a company’s IPO process and provide research to the buy-side before the company actually went public. Sell-Side Analysts’ jobs involved forming relationships with and talking to the managements of the companies, following trends in the industry, and ultimately making buy or sell recommendations on the stocks.

Buy-Side Analysts - Institutions that do the actual buying and selling of public securities such as mutual fund companies, insurance companies, hedge funds and other asset managers. Their functions are similar to sell-side analysts. However, buy-side analysts are usually assigned to a group of companies within a certain industry and were responsible for doing industry research, talking to the companies’ management teams, coming up with earning estimates, doing valuation analysis and ultimately rating the stock prices of the companies as either “buys” or “sells.”

Portfolio Managers - Managers who actually managed the money. They listen and consider the recommendations of the analysts but they are the ones who ultimately make the decisions.

Accountants & Auditors - Audit public companies’ financial statements to verify their accuracy and freedom from fraud. Investors usually carefully consider the auditors’ opinions to assure the quality of the information they were receiving from companies.

FASB - The Financial Accounting Standards Boards: an independent regulatory body in the United States whose mission was to “establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of the financial information.” The FASB acted as a regulator for the financial reporting of public companies.

2) How is each of the intermediaries that you identified compensated for performing its respective function? Is the compensation arrangement likely to lead to any dysfunctional incentives? Please explain.

The intermediaries are compensated differently. For example, venture capitalists will fund companies before the IPO so they often look for companies that will offer them high returns once they go public. Important qualities that VCs look for are good business models and strong management teams. VC’s compensation comes from a large share of the company’s profits in addition to a low management fee. This compensation, in isolation, does not seem to have dysfunctional incentives, as their interests are typically aligned with their investors.

The underwriting investment banks are paid on a commission based upon how much money they raise during the offering. This could be dysfunctional because the underwriters are likely to push the public hard about the company’s prospects. The investment banks get paid regardless of what happens to the stock after the initial offering so even though tech stocks were taking a dive, the investment banks had already been paid large commissions.

The sell-side analysts are partly compensated on a basis of trading fees and banking revenue they help the firm generate with their research and ideas. The incentive here may be to provide optimistic recommendations to boost investment banking revenue.

Buy-side analysts are compensated based on how well their stock recommendations do so they are more likely to be more thoughtful in their analysis than sell-side analysts. Portfolio managers who take recommendations from the buy side analysts are compensated based on the performance of their funds relative to the market index. Their interests are typically aligned with that of investors.

Money management firms can act on behalf of the individuals by creating portfolios that provide limited risks with returns that will try to beat the market standard. Portfolio managers have a fiduciary duty to follow an investment strategy with a level of risk that is acceptable to the investor. They are likely to act more responsibly so they can continue to have repeat business from investors.

Accountants create and audit the financials which become the basis of a company’s fundamentals. They are typically compensated either by the company or a third party that has hired them to audit. Attorneys are also compensated by the company or the underwriting company to review the terms of the IPO.

Media is compensated by gaining traffic to their networks, sites, and channels. The media will try to draw investors into their channels but often can provide misleading information or heavily biased information. Analysts that provide analysis of companies will try to sway the public by pumping their stocks.

3) Identify the role that 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?

After the dot com bubble burst, many people blamed the Venture Capitalists for backing these tech companies. They, like the market as whole, were being influenced by “euphoria of the market” and investing in firms they otherwise would not have. Studies show that after receiving funding, VCs were taking these companies public much sooner than in the past. The readily available funding by VCs also influenced the behavior of the companies thereafter. The VCs contributed to the high valuation expectations which indirectly created pressure for public to invest. Mutual funds began to behave like Venture Capitalists by investing in the dot-com companies with questionable records.

The Invest Bank Underwriters also contributed to the bubble. In one case, Merrill Lynch took Pets.com public only for it to file for bankruptcy within nine months after the IPO. Though many of these tech companies and their investors were losing money, the Investment Banks had already been paid their fees. They took advantage of the overvaluation of the tech stocks and failed to provide advisory financial services for the companies.

The sell-side analysts were equally optimistic on the tech companies in the days leading to the dot com meltdown. They were providing BUY ratings on companies that were at their peaks, shortly before the crash. They argue that while many of the analysts were aware the stocks were overvalued, they believed it would have been a mistake to be negative. They wanted to recommend capitalizing on the positive attitude of the market rather than the true value of the stock.

The buy-side analysts and portfolio managers were expecting more on the stock prices rather than the stock quality; focused on “outperforming” their competitors. The conservative ones who felt the companies were already overvalued sometimes bought the stocks anyway in fear of being left behind.

The accountants and auditors are also responsible because they overlooked the early signs of this crash, for example, the abnormal financial activities, and didn’t adequately warn investors. They were criticized for not being thorough enough in their assessments of the companies’ contracts. The FASB, the Financial Accounting Standards Boards, was supposed to have been regulating the accounting practices, but the “new economy” posed new challenges. Some argued that an entirely new system was needed to account for intangible assets. On paper, these internet companies were appearing unprofitable when they were actually doing well.

4) What else would you recommend to fix the underlying problems of this case?

Answer here, single spaced