“It was well-choreographed, a beautiful show, but what was the financial truth?” Christian Ogier, Paris dealer commenting on one of the Christie’s auctions, May 2015.
By Jessica M. Curley*
Fine art is known to have little intrinsic value beyond its cultural significance and aesthetically pleasing nature, yet it seems to be an increasingly attractive alternative to traditional investment assets. The CEO of Blackrock, Larry Fink, recently remarked that one of the “two greatest stores of wealth internationally today is contemporary art,…” adding that, all jokes aside, it is a “serious asset class.” Although many art world enthusiasts advise that people only purchase art if they truly admire it, recent record high sales and huge upside potential are attracting the attention of those more focused on profit making. One mechanism utilized by some of these profit seekers to gain exposure can be found in fund-structured vehicles sometimes referred to as “passion funds.” These art investment funds, or “passion funds,” provide the opportunity for investors to tap into the potential of art works to diversify portfolios and potentially obtain significant returns. While some money managers have also taken interest in other niche asset classes including fine wine, vintage vehicles, stringed instruments, rare gems, and even comic books, this article focuses primarily on fine art.
Background & Market
Individuals and private clubs have been collecting fine art with varying degrees of investment intent for hundreds of years. However, the first institutional investor to specifically allocate capital for the purpose of investing in art is widely considered to be the British Rail Pension Fund, having acquired about 2,500 objects during the 1970’s for a total cost of about $70 million USD, close to 3% of the total fund. Institutional investing in art works has evolved since the 1970’s, resulting in the emergence of more and more funds exclusively dedicated to the asset class. The collapse of the dot-com bubble in 2001 also fueled the art fund trend as investors looked outside of the market for alternative opportunities. This trend of looking towards alternative assets was seen again following the financial crisis of 2008, as investors increasingly focused on tangible assets and alternative types of investment opportunities. Shortly thereafter, 2010 saw record sales of art works at both Christie’s and Sotheby’s, which further demonstrated the potential offered by fine art. More recently, in 2014 the global art market reached the highest level ever recorded, a total of over €51 billion.
Managers of art funds are typically professionals from the financial industry, who have an interest and/or experience in the art world. They provide a number of crucial services including fundraising, investor relations, strategy development, market monitoring, and management of the disposition of fund assets. One notable example can be seen in Ron Perelman, billionaire businessman and art enthusiast, who established MAFG Art Fund for the purpose of investing in fine art, and who recently made headlines after getting caught up in a series of unfortunate transactions (read more here).
Art fund investors generally have some kind of prior knowledge of the art market, and are largely looking to this type of asset for diversification and hedging purposes. To qualify to invest, they must be considered “accredited investors” under SEC guidelines, meaning that they are financially sophisticated individuals or institutions that require less protection than their unsophisticated counterparts. Institutional investors commonly include pension funds, trusts, family offices, insurance companies, endowments, and sovereign wealth funds, among others. For an individual to qualify for “accredited investor” status they must meet one of the following three criteria: (1) have a net worth exceeding $1 million, either individually or jointly with a spouse; (2) have an individual income in excess of $200,000 per year; or (3) have a joint income of $300,000 during each of the last two years and reasonably expect the same level of income moving forward.
Art funds are transactional in nature. They typically generate returns by strategic purchase and sale of artworks. In the US, art funds generally adhere to the traditional hedge fund structure of a limited partnership (typically in the form of a limited liability company (“LLC”)), which consists of a managing general partner(s), and a limited partner(s) who invest in the fund. Offshore funds can take on a number of more complex feeder/master fund formations, which also usually take on the form of a limited partnership, albeit with a wider variety of structuring options depending on source(s) of investment capital, taxation and accounting preferences. An open-ended fund scheme allows for the admittance of new investors and withdrawal of current investors throughout the life of the fund. More commonly used are close-ended funds, which, as the term implies, are closed to new investors once the fixed term to raise capital has ended. A third option consists of a hybrid model, which is more closely related to a close-ended fund, but which allows for some liquidity as investors can redeem shares after providing notice. Despite the likely existence of a withdrawal fee provision, the hybrid model boosts marketability since it provides for a quick exit for investors who do not like their capital locked up.
Once the structure is created and fund raising commences, a private placement memorandum detailing the objectives, risks and terms, including the investment minimum, of the offering is drafted and provided to potential investors. When an investor decides to invest, a subscription agreement detailing number of shares, price, and other terms will be executed resulting in the investor becoming a shareholder in the fund. One prominent art fund, the London-based Fine Art Fund Group, established in 2001, has six separate funds each of which is composed of an investment minimum of between $500,000 and $1,000,000 by 30 to 40 individual or institutional investors. Under some circumstances, investors may redeem shares, or sell to another accredited investor through a private placement, but this is typically limited or prohibited by the agreement terms.
It is unknown exactly how many art funds exist today. Recently, Center for Art Law sat down with Enrique Liberman, President of the Art Fund Association, who has advised that there may be around 45 total funds worldwide. Most art funds are private investment vehicles, and as such are not subject to public disclosure and other burdensome regulatory requirements. Those art funds that are private investment vehicles must abide by the Regulation D private placement exemption requirements under the Securities Act of 1933 (the “33 Act”), which include limiting the offer to “accredited investors,” disclosing all material elements of the investment opportunity in a private placement memorandum and subscription agreements, and filing notice with the Securities and Exchange Commission (“SEC”) and with any relevant state regulators. To avoid being defined as an “investment company” under the Investment Advisers Act of 1940 (the “40 Act”), and thus subject to its additional set of regulatory burdens, art funds must qualify for one of two exceptions: having less than 100 investors or having up to 499 investors who meet the definition of “qualified purchasers.” Art funds are also subject to the anti-fraud provisions promulgated in the 33 Act, the Securities Exchange Act of 1934 (the “34 Act”) and the 40 Act, which prohibit fraud in connection with the offer and sale of securities and in connection with advisory services. Art fund managers themselves must register as investment advisors with the SEC, under the 40 Act, if either they engage in significant leveraging and securities trading strategies, or the art fund exceeds the $150,000,000 threshold for “assets under management,” which are rare. Art fund managers may also need to register if required by state laws.
In contrast to the heavy regulation and transparency of the financial markets, the art market is currently burdened by little oversight. Art assets acquired by funds are not subject to the same level of investor protection measures as securities and other financial instruments. Aside from anti-fruad provisions, auction regulations, cultural property laws, and general consumer protection and contract law, not much regulation exists, which is a definite worry for some art market investors. James R. Hedges IV, financier and art collector, was quoted by the New York Times commenting on the state of art market regulation in that “the art world feels like the private equity market of the ’80s and the hedge funds of the ’90s…it’s got practically no oversight or regulation.” In the same vein, Nouriel Roubini, co-founder and chairman of Roubini Global Economics, has advised that the art market is prone to abuse through “routine trading on insider information,” and is used for money laundering and tax avoidance purposes.
Additionally, art funds tend to be discreet in their communications due to solicitation and advertising restrictions under Regulation D. Hence the scarcity of information available about the strategies, operations, and returns of art funds. Generally speaking, art funds may adopt broad investment strategies or alternatively may be more refined, for example, focusing on acquiring art of a specific genre or geographical region. Works from certain genres or regions can be more profitable than others due to a number of factors, including trends, cultural awareness, and economic growth and prosperity. For example, Post-War & Contemporary art has outperformed Impressionist and Old Masters for the last two decades according to the Mei Moses Fine Art Index, and has even outperformed the S&P 500 for the last ten years. Fine Art Fund Group CEO Philip Hoffman has advised that the firm began by investing in Old Masters, Impressionist, Modern and Contemporary Art, and have since expanded into “emerging art” genres. It has also been disclosed that the first two funds produced annual returns of 16 percent for sold pieces, a figure based on the sale of about 100 artworks.
More is known about fee structures than investment strategies. The two most common fees include a management fee of about 1 to 2 percent, and a performance allocation fee of around 20 percent of the net income of the fund per annum. Additional costs associated with art funds include traditional expenses incurred by collectors: commissions, buyer’s premiums, shipping, storage and insurance. That said, art funds generally try to avoid transacting through auction houses so as to avoid hefty sales commissions and buyer’s premium expenses. The Collectors Fund, based in Kansas City and established in 2006, manages between $20 and $30 million raised from around 100 investors each having contributed a minimum of $100,000. Once works are sold, a 20 percent management fee is skimmed from the net profits. From the remainder, 40 percent is distributed to investors, while 60 percent is reinvested and used to purchase additional works.
Pros & Cons
Art funds offer many unique advantages to investors. The value of fine art is generally uncorrelated with traditional financial markets, providing a means of diversifying portfolios, and hedging against market downturn and inflation. Art typically holds its value, especially on the higher end, and has consistent performance returns, which are very attractive characteristics to investors. Although the art market is subject to little oversight, actual art funds are subject to some financial industry regulation and must comply with initial and periodic disclosure requirements, and antifraud provisions, which provide some level of investor protection. Art fund managers also have a fiduciary duty with regard to their investors, which is virtually non-existent in gallery-investor or auction house-investor relationships. Additionally, fine art has an inherent appeal as a luxury good, and depending on the fund, may be loaned out to investors for personal use.
One potential drawback of art fund investing is that traditional financial modeling does not generally work due to the unique nature of art works and trends in the art market. For investors who are accustomed to relying at least partially on traditional models, this may cause some discomfort. Another concern is that art funds require professionals who can strategically advise on the purchase and sale of art works; however, this is a difficult skill to qualify as past performance is often hard to measure. Limited liquidity is a major issue facing art fund managers and investors; art must be sold according to market trends in order to maximize returns, which may not coincide neatly with the close of a fund. Furthermore, as previously mentioned, unlike the financial markets, the art market is highly unregulated leading to less investor confidence in fair dealings, and more potential for price fixing and manipulation. The issue of valuation presents another problem for art funds as the value of acquired works remain that of the purchase price, not accounting for any shifts, until there is a liquidity event, making it hard to value a fund at certain benchmarks. Provenance issues, including forgery, looting events, and misattribution, are also pervasive in the art world and may arise if proper research is not carried out prior to purchase. To this end, title insurance may be purchased to protect a fund against a murky provenance.
Looking to the Future
As the interest in fine art investing continues to increase, new variations of the art fund are popping up, providing new ways for investors to access the art market. One such variation is Arthena, the first equity crowdfunding platform that allows investors to pool their capital in “collections” which are curated by expert art advisors. The minimum investment per collection starts at $10,000 providing access to a much broader group of investors than the typical art fund, with a floor of upwards of $100,000.
The art investment industry has also seen a recent trend of investors moving away from art funds and towards privately managed art investment accounts. This allows investors to avoid co-mingling their capital and provides the opportunity to customize the objectives and strategies of the investment.
In addition to these alternatives, new products are in the pipeline that would provide other methods for investing in the art world. Missouri based Liquid Rarity Exchange plans to bring one such product to market in the next few years, which will consist of publicly traded shares of securitized art and other tangible and intangible alternative assets. Shower Zhang, Director of Strategic Planning, has advised that in one interesting scenario, the owner of an art collection, be it an individual or institution, can essentially bring the collection to market through an IPO process, governed by standard SEC regulations. The shares then being traded on the open market. Another product, this one emerging from the banking world, is a collateralized debt obligation (“CDO”) utilizing art loans as the underlying asset. A traditional CDO is a structured investment product that utilizes cash flow-generating assets, including mortgages, loans, bonds, and credit card debt, and bundles them into tranches that can be sold to investors. An art CDO would theoretically operate the same way, only using loans backed by art works as the underlying assets. The art lending business has grown significantly in past few years as banks, auction houses, and private lenders seek to provide this additional service for high net worth clients, and as such, it makes sense that financial institutions would create sophisticated ways to further monetize these loans.
In conclusion, the subject of art funds has seen about as much enthusiasm as it has criticism from the financial industry. However, it is worth noting that what most people today consider mainstream alternatives (hedge funds, private equity and real estate) were not always considered to be so. This leaves open the possibility that art investment, and particularly art funds, may follow in their footsteps. In the meantime, those considering investing in an art fund are strongly advised to do their research and seek the advice of experts in the field.
- The Art Fund Association, http://www.artfundassociation.com/index.html
- Cristina del Rivero, Art Meets Law in New York Times art securitization piece (Jan. 11, 2011) http://artmeetslaw.blogspot.com/search?q=securitization
- Cynthia O’Murchu, Art: A Market Laid Bare, Financial Times (Apr. 7, 2015)
- Daniel Grant, Dollars on the Wall? Art Funds Boom Along With Auction Houses, Observer.com (May 14, 2014, 2:58pm) http://observer.com/2014/05/dollars-on-the-wall-a-booming-art-market-attracts-investors/#ixzz3Zyu3C0XX
- James B. Stewart, With Art, Investing in Genius, The New York Times (Nov. 28, 2014) http://www.nytimes.com/2014/11/29/business/with-art-investing-in-genius.html?_r=0
- Katherine Markley, Q&A with Art Fund Association President Enrique Liberman, artnet news (Sep. 9, 2013) //news.artnet.com/market/q-amp-a-with-art-fund-association-president-enrique-liberman-48644
- Kyle Sommer, The Art of Investing in Art, https://www.jpmorgan.com/pages/jpmorgan /is/thought/magazine/3Q2013/art
- Madeleine Giansanti Cag, Want To Invest In An Art CDO? I’d Pass (Jan. 9, 2015, 3:30pm) http://abovethelaw.com/2015/01/want-to-invest-in-an-art-cdo-id-pass/
- Marion Maneker, Blackrock’s Fink Validates Art as an Asset Class (Apr. 21, 2015) http://www.artmarketmonitor.com/2015/04/21/blackrocks-fink-validates-art-as-an-asset-class/
- Marion Maneker, Mysterious Art Funds—and Why They’re That Way, Art Market Monitor (Mar. 11, 2015) http://www.artmarketmonitor.com/2015/03/11/mysterious-art-funds-and-why-theyre-that-way/
- Mike Collett-White London, As art market booms, some see the risk of bust, Reuters (Feb. 3, 2011) http://www.reuters.com/article/2011/02/03/us-market-preview-idUSTRE7124B720110203
- Noah Horowitz, Art of the Deal: Contemporary Art in a Global Financial Market (Aug. 31, 2014)
- Robin Pogrebin and Kevin Flynn, As Art Values Rise, So Do Concerns About Market’s Oversight, The New York Times (Jan. 27, 2013) http://www.nytimes.com/2013/01/28/ arts/design/as-art-market-rise-so-do-questions-of-oversight.html?_r=0
- TEFAF, Global art sales in 2014 break all known records (Mar. 11, 2015) recordshttp://www.tefaf.com/DesktopDefault.aspx?tabid=15&tabindex=14&pressrelease=16959&presslanguage=
- Terry Trucco, British Pension Fund Sells $65.6 Million in Artworks, New York Times (Apr. 5, 1989) http://www.nytimes.com/1989/04/05/arts/british-pension-fund-sells-65.6-million-in-artworks.html
About the Author: Jessica M. Curley, Esq. (Cardozo ’14) is pursuing her interest in art law and financial regulation in New York. She served as the Spring 2015 Post Graduate Fellow with Center for Art law, and currently works in fund structuring at a large financial institution. She may be reached at email@example.com.
Disclaimer: This article is intended as general information, not legal advice, and is no substitute for seeking representation.