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It’s a rite of passage for any budding hedge fund manager to buy some art. For me, it happened a number of years ago. I’d just bought a new house and one particularly plain wall screamed out for adornment. The house itself was a nice place to live, but it also served as an investment; why not extend that duality to the internal decor? If I could brighten up my walls and earn a return at the same time, what’s not to like?

Trouble is, while I knew my way round the equity market (I was a budding hedge fund manager after all) I had no idea how to navigate the art market. Fortunately, one of my close friends is an art historian with expertise in contemporary art; he agreed to be my sherpa through this unfamiliar terrain.

It didn’t take long for my friend to identify an up-and-coming artist he thought worth backing. She was represented by a swanky Mayfair gallery and we arranged to meet there for a viewing. I was eager to go straight in, cheque book in hand. But my guide stopped me. Apparently I would first need some coaching.

It seems that buying art from a gallery isn’t like buying a regular item from a store. The gallery owner is less your typical retailer and more a kind of gatekeeper. Which meant I needed a story. To even be considered a prospective buyer, I needed to dispense with the budding-hedge-fund-manager shtick and assume the role of collector. Like a spy about to go undercover, we rehearsed my story: I had viewed numerous other pieces by a range of artists and was embarking on a multi-year project to build up a collection. I wasn’t in it for the money; I was in it for the aesthetic. 

Art represents a $1.7 trillion asset class. That makes it bigger than private debt and about half the size of private equity. Its centres of gravity line up with those of international finance. In London and New York, the biggest art galleries and auction houses sit blocks away from the biggest hedge funds and banks. Financiers are known to be active collectors of art. A few years ago, Ken Griffin of Citadel bought a Willem de Kooning and a Jackson Pollock for a combined total of $500 million (and more recently a copy of the Constitution for $43 million). Steve Cohen, founder of Point72, has spent over $1 billion on works by artists including Andy Warhol, Pablo Picasso, Jasper Johns and others. And one of the biggest corporate collections in the world is owned by Deutsche Bank, its value more than Deutsche’s earnings in a typical year. Yet in spite of the overlap, the market operates very differently from traditional financial markets. 

Historically, the art market worked on a patronage system where owners would act as stewards of artists’ work and seek to maintain their legacy. Speculation undermined this model, hence the need for gatekeepers. By allowing patrons to pass through while keeping speculators out, dealers brought order and stability to the market. In this model, monetary value isn’t the prime focus. The very architecture of a gallery banishes commerce to a back room, the front exhibition space cleansed of monetary fingerprints. By law in most markets, galleries must have set price lists, but you have to ask for them – they are never displayed in the shop window.

This market structure affords dealers a lot of power. They create a market for the artists they represent and maintain it by controlling price levels, tempering speculation and courting influential buyers. The heterogeneous nature of the market, where every item is unique, further supports a dealer-intermediated model. 

Dealers have a pecking order of preferred buyers. At the top are museums, because nothing beats the endorsement of a recognised museum. An exhibition at the Museum of Modern Art (MoMA) in New York, say, would boost an artist’s career trajectory enormously. The museums know it, but they are coy about the monetary impact they can have on an artist’s work. Glenn Lowry is director of MoMA: 

“We do not create financial value. We may, incidentally, create financial value by making a larger public aware of an artist’s importance. But the value we create is art-historical importance.” [Source]

Beneath the museums, sit the top collectors. There’s a bit of overlap between the two categories. Many top collectors sit on museum boards and so have some influence over the works they buy or exhibit. Collectors may donate works to a museum to enhance their value. But it’s a rarefied market; there are a limited number of top collectors. 

Beneath the collectors are the budding hedge fund managers. Asked what would happen if an unknown customer walked into his gallery offering to buy a painting on display, gallery owner David Zwirner says:

“Um — that’s a good question, because that happens so rarely that I have to step back for a second. I would want to know who you are. So the transaction would not be instantaneous. It would be, “Let’s get to know each other.” And we would find common ground — people that we know, art that you collected that I would know, and we would become friends, and you become a client.”

While the monetary dimension of art is downplayed in the primary market where dealers operate, in the secondary market of auction houses, it is front-and-centre. There’s no hiding the prices at which artworks transact there. This year alone, Sotheby’s has made $7.3 billion of sales, including 57 pieces valued in excess of $15 million (yes, that includes the Constitution).

Auction houses have a rich and storied history. But their influence on the contemporary art market can be traced back to 1973. In October that year, Parke Bernet, part of Sotheby’s in New York, auctioned off fifty contemporary artworks owned by the taxi tycoon, Robert Scull. Almost all the works fetched record prices. In particular, Scull made a large profit on a Robert Rauschenberg that he had bought fourteen years earlier for $900; it went for $85,000 at the auction. Rauschenberg wasn’t happy: “I’ve been working my ass off for you to make that profit,” he declared. Scull replied, “I’ve been working for you too. We work for each other.”

Today, around 50% to 60% of market sales volume is controlled by dealers, with the rest passing through auctions. While the secondary market doesn’t yield direct economic benefits to the artist or to the dealer, to the extent it leads to higher prices, anybody with inventory or a pipeline of new inventory benefits. Such bifurcation could have led to dealers losing control of the market, but that didn’t happen. There are a number of reasons.

First, there is a high degree of concentration among the top dealers. Fewer than 5% of them are responsible for more than 50% of the sales value. This concentration percolates through the entire market. The top 20 artists (represented by the top few dealers) make up nearly 50% of the auction market for post-war and contemporary art. This gives dealers the weight to manage the gap between the primary market and the secondary auction market. In particular, they discourage arbitrage, where works are immediately flipped on the secondary market for a gain. 

A second reason is that the overall market is largely unregulated. This allows dealers to adopt practices that would be frowned upon or downright illegal in securities markets. Back in 2008, on the very day that Lehman Brothers declared bankruptcy, Sotheby’s hosted an auction in London of 218 works by Damien Hirst. Michael Shnayerson writes about it in his book, Boom: Mad Money, Mega Dealers, and the Rise of Contemporary Art:

From outside the auction house, the two-day sale seemed a great success. It brought 21,000 visitors and generated $200.7 million in sales. But many of the works sold were propped up by Gagosian and Jopling, who bid on them hoping to elevate Hirst’s market enough that they could quietly sell off the works they had on their hands. In fact, Hirst’s market was too far down for that: works he had sold between 2005 and 2008, his highest-selling years, were selling at 30 percent discounts, if they sold at all. In the following weeks, rumor had it that more than a few buyers had reneged.

A few months later, with the market recovering, art dealer Larry Gagosian and collector Alberto Mugrabi looked to buy some Andy Warhol paintings at a Sotheby’s auction in London. Mugrabi was overheard speaking to the Sotheby’s director in advance. According to Shnayerson:

“My dad said that he can pay for the two pictures—for the Hammer and Sickle and the shoes—£2 million, all inclusive.” Mugrabi, then, was telling Sotheby’s—and the seller—what to set as the reserves, and at the same time establishing what he and Gagosian would pay to keep the paintings from being bought in. Mugrabi and Gagosian would be going in with information no other bidder possessed: what the reserve was.

Evolving Market Structures

Market structures are never static and the structure around art is evolving. The higher price point in art, its heterogeneous nature, high ownership costs, and the non-transparency of its market all differentiate it from traditional financial markets. But one takeaway from financial markets is that when assets become more legible, they become more tradeable, and that’s happening in art. The deployment of technology has allowed price datasets to be created for artworks, removing some of the opacity from the market:

• Artnet was founded in Germany in 1989 with the goal of bringing transparency to the art world. It has compiled a database of over 12 million past auction results including prices, images and detailed descriptions. The company sells access to its database. It has been listed on the Frankfurt Stock Exchange since 2007, but its stock has risen dramatically post pandemic (+330% since end March 2020, albeit its market cap is only $70 million).

• Magnus Resch, a German art expert and entrepreneur, wrapped a price database in an app, Magnus, which he describes as the “Shazam for art”. In order to capture primary market pricing data, he encouraged users to take photos of artworks displayed in galleries and log their prices. By 2016, he had price data on 8 million pieces of art (compared with 9m in Artnet at the time). However, an association of German gallery owners became unhappy that their artists’ prices were being catalogued, and complained. Apple took the app down from its app store for a while, but it was reinstated later. 

• Masterworks was founded in New York in 2017 to facilitate fractional ownership of artworks. As a precursor, the founders wanted to create a definitive art index. They built a price database compiling over 3 million data points from over 300,000 auction transactions going back to 1960. Based on the model developed by Case-Shiller for the housing market, their index looks at repeat sales of the same artwork in order to measure like-for-like price appreciation. They are currently offering fractional ownership of a Gerhard Richter; historical price appreciation of his similar works is 14%. 

In securities markets, increased transparency typically leads to increased liquidity. As in finance, there are vested interests in retaining opacity. Dealer take rates are as high as 50% so many are loath to change. But the trend is difficult to reverse. An interesting precedent is the real estate market, which was opaque and illiquid until securitisation and the creation of real estate investment trusts (REITs) in the 1960s. Investor participation has grown steadily since.  

One beneficiary of all this is Sotheby’s. The company recently announced that it’s had a record year – the highest sales in its 277 year history. In particular, it is seeing a wider audience from new sale formats. Underpinning its record sales was a record number of bidders, with 44% of them new to Sotheby’s.

Sotheby’s was taken private in 2019 by Patrick Drahi for $3.7 billion but he recently signalled that he may look to relist it in New York next year. Twenty years ago, the company was fined for price-fixing after US federal antitrust investigators alleged it colluded with Christie’s to set the same commission fee structures. It moved on from that, but the auction market remains very concentrated, with half the market going through five auction houses globally. In the late 2000s, Sotheby’s auction margins were as high as 20%.  

Of course, Sotheby’s recent success may be a manifestation of the same market phenomenon that has increased investor excitement about a range of different assets. But the market for art investment could be opening up. Two hundred years ago, it was very common to have 20 to 30 artworks per household. With gatekeepers tamed, that could become the norm once again, even if many of the artworks are digital.

Happy Holidays

This is the last Net Interest of the year! I look forward to continuing to deliver insights into 2022 but if you want to get in touch in the meantime, please do hit ‘reply’ to this email. And if you fancy giving a Net Interest subscription to someone as a holiday gift, you can do so by clicking here.

Wishing you a great holiday season,

Marc