1. What is the intended role of each of the institutions and intermediaries discussed in the case for the effective functioning of capital markets?
The institutions and their roles are as below:
* Venture capitalists: VC’s provide capital to high potential, high risk companies in their early stages of development. In return they seek to provide very high rate of return to their investors for the associated risk. VC’s screen for good business ideas and management teams from the bad ones. They then work closely with these management teams, monitoring and guiding them, so that the business idea is transformed into a well-managed fully functional company that can stand on its own. These ...view middle of the document...
However their research is not available to anyone outside the fund, and the analysts also need to convince portfolio managers within the company to follow their recommendations.
Portfolio managers are the ones actually responsible for investing at buy side institutions. They seek advice from analysts about particular stock investment.
* Accountants and auditors: Independent accountants audit financial statements of public companies to verify their accuracy and ensure the statements are free from fraud. If accountants are not fully satisfied with the way company has maintained its accounts then they will issue qualified opinion indicating that the information within the document is not complete.
* Regulator – FASB: The regulator’s mission is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information.
2. Are their incentives aligned properly with their intended role? Whose incentives are most misaligned?
The incentives and intended roles of certain players in the investing and information chain were substantially misaligned thus causing a breakdown in the effective and well-functioning of capital market. The misalignment was very high in the case of:
* Sell side analysts: At the time of dot com bubble the concept of Chinese wall/firewall was not strictly enforced in investment banks. Sell side analysts were partly compensated based on the amount of trading fees and investment banking revenue they helped the firm generate through their research. So there was no incentive for these analysts to be neutral when it came to recommending stocks of companies which had banking relationship with their firm. The potential deal flow did distort the views of some technology analysts during the boom.
Tremendous market liquidity and interest in young new economy companies were pushing the stock prices of these companies higher each day. This made analysts valuation-insensitive and they gave positive recommendation on stocks just based on expected stock market movement.
* Buy side analysts and portfolio managers: Compensation of buy side analyst’s is linked to the performance of their recommended stocks. Hence these analysts began to recommend overvalued stocks simply because they knew that the stock prices would go up.
Compensation of portfolio managers is determined by the performance of their funds relative to an appropriate benchmark. These managers felt that if they did not invest in dot com companies they would lag performance of their benchmarks as well as competitors funds. Hence they...