A Solution To The Block Pricing Puzzle

There are two ways to buy a large percentage block of stock-either buy it from another shareholder in a block trade or directly from the corporation in a private placement. Given that a buyer ends up with a large fractional block of stock after both transactions, the per-share premium or discount to the exchange price should be similar. But this is not the case.

"It's what we call the block pricing puzzle," says Dennis Sheehan, professor of finance in Penn State's Smeal College of Business Administration. "Block trades tend to be priced at large premiums to the exchange price, while private placements tend to be priced at large discounts. There is a 30 percentage point difference in pricing."

Sheehan co-authored a study, "The Block Pricing Puzzle," which offers explanations for the difference in pricing. The study--co-authored with Michael J. Barclay from the University of Rochester and Clifford G. Holderness from Boston College-was presented at last month's American Finance Association Meeting in New Orleans.

"We believe the solution to this puzzle comes from the eventual organizational roles of the purchaser," says Sheehan. "Compared with purchasers of private placements, purchasers in block trades are more likely to become involved in firm management, and there are frequent changes in control of the firm following the trades. This suggests that the premiums associated with block trades typically reflect private benefits that the block purchaser anticipates from eventually controlling the firm."

Following most private placements, however, the purchasers remain passive. These trades are typically priced at substantial discounts to the exchange price. Furthermore, Sheehan says, stock prices decline thereafter, but the firms are seldom acquired in spite of this poor performance.

"These findings raise the possibility that in some private placements the block discounts are implicit compensation for helping to entrench management from the market for corporate control. We call these entrenching blockholders," says Sheehan.

One plausible explanation for some private placements is that alternative methods of raising capital, such as a public offering of equity or a bad debt issue, offer less assistance to management in the event of a disgruntled board of directors or an unwanted takeover attempt.

"Having a large block of stock in friendly hands under such conditions can be beneficial to management personally," says Sheehan. "The block pricing puzzle arises because active blockholders are more likely to enter though block trades, while entrenching blockholders enter only through private placements."

Sheehan notes that once the researchers controlled for whether a block purchaser becomes active, the method of sale-block trade or private placement-had little bearing on the pricing of a block.

"It is the substance of a blockholder's involvement with the firm, rather than the mode of his entrance, that explains the pricing of large-percentage blocks of stock. Once this is understood, there is no block pricing puzzle," says Sheehan.