ARTFA | The Art Fund Association (2024)

Art funds are generally privately offered investment funds dedicated to the generation of returns through the acquisition and disposition of works of art. They are managed by a professional art investment management or advisory firm who receives a management fee and a portion of any returns delivered by the fund.

The underlying characteristics of art investment funds are diverse and vary from fund to fund. While all art funds utilize some form and degree of a traditional “buy and hold” strategy, art funds differ in their aggregate size, duration, investment focus, investment strategies and portfolio restrictions.

The unifying factor of all art investment vehicles is their focus on the art market, which is characterized by a lack of regulatory authority, deficient price discovery mechanisms, the non-transparency of the market and the subjective value and illiquid nature of fine art. Proponents of art investment funds argue that it is these very characteristics that generate the significant arbitrage opportunities within the market that seasoned art professionals can exploit for the benefit of the fund’s investors. Likewise, critics of art investment funds in turn point to such characteristics as denoting art as the riskiest asset class, thereby creating the potential for substantial investment losses among the fund’s investors.

Most art investment funds are administered by a professional investment management firm that is usually comprised of a mix of experienced art market professionals and professional investment advisors from more traditional hedge or private equity funds. Such a pairing is essential to avoid many of the pitfalls inherent to managing an art fund –namely either a lack of experience in the ins and outs of the art market or in managing an investment fund. Hedge fund managers will likely view art as an asset like any other to be traded and sold without having the background to identify works with the potential for price appreciation or the ability to gauge their authenticity or condition. Likewise, a former gallery owner or art dealer would likely be overwhelmed by the intricacies of raising money for, and administering, an investment fund.

As a general rule, art fund managers typically have a substantial amount of their own capital invested in the art funds that they manage, thereby aligning their interests with those of their investors.

Art fund managers perform a number of tasks for the fund such as:

• identifying potential acquisitions
• raising capital for the fund
• managing investor relations
• handling administrative compliance for the fund
• showcasing the investment portfolio of the fund through exhibitions and loans to museums
• managing the investments including storing and properly insuring the art
• monitoring the art market in general and the fund’s artists in particular
• managing the orderly disposition of the fund’s investment portfolio

The fees charged by art fund managers are primarily tied to performance, which serves to align the interests of such managers with those of the art fund’s investors. Typically, art fund managers charge (i) an annual management fee of between 1% and 3% of either the net asset value of the fund’s art portfolio or the total capital commitments made by the fund’s investors and (ii) a performance fee equal to 20% of any profits made from the disposition of the fund’s art portfolio.

While individuals have been acquiring art in art clubs or similar collectives for investment purposes for centuries, the British Rail Pension Fund (the “BRPF”) was the first to formally adopt the rubric of what we would today call an art investment fund. In 1974, a portion of the BRPF’s capital was invested in over 2,500 works of art during a six-year period. The BRPF was reportedly able to deliver an aggregate return of 11.3% per year compounded from 1974 to 1999.

After BRPF’s foray into the art fund arena, there were over 50 proposals to create art investment vehicles, some offered even by certain of Wall Street’s most prominent financial institutions. Such proposals never truly got off the ground and other attempts that followed met with disastrous results due to, among other things, overpaying for their art works and failing to properly manage their operational expenses.

Today there are a number of funds that have successful launched. Most famous of which is The Fine Art Fund founded by Phillip Hoffman, a former executive at Christie’s auction house. While the results of The Fine Art Fund are not publicly disclosed, such fund is rumored to be doing well, and its managers have either launched or announced plans to launch other funds focused on the Chinese and Indian contemporary art markets.

Notwithstanding the foregoing, it is clear that the art fund industry is today at a crossroads and the ultimate direction of the industry will ultimately be decided by whether art fund principals, professionals and promoters are able to convince the investment community that art funds are not simply a recent curiosity but a valid and permanent part of the alternative investment world.

With the art fund industry in its early stages, it has been a challenge for art funds to raise sufficient capital. The most significant investors in hedge and private equity funds – namely university endowments, pension funds and insurance companies – have been reticent about investing in art funds, leaving art fund managers to rely on a restricted class of angel investors with whom they have preexisting personal relationships.

Equity interests in art funds in the United States are not offered for sale to the general public in order to meet certain exemptions from registration under U.S. securities laws. Such exemptions require art funds to comply with statutory and regulatory regimes that relate to private offerings, including, but not limited to, limiting their offerings to “accredited investors”, namely certain institutional investors and individuals with either a net worth of $1 million (excluding the value of their personal residence) or with income during the past two years of $200,000 (or $300,000 with spouse), with whom the art fund has a pre-existing relationship arising out of other than the art fund offering. Art funds may permit up to 35 investors to be non-accredited; however, to do so requires more significant financial disclosures and presents additional challenges with respect to compliance by the art fund with state “blue sky” filings.

Art funds in the United States also seek to fall within one of two exceptions from the Investment Company Act of 1940 (the “40 Act”) in order to avoid the need to register as an “investment company” under such act, which is another word for a mutual fund, which impacts the number and character of the investors in such funds.

Section 3(c)(1) of the 40 Act provides that an art fund can avoid registering if its equity interests are sold privately to no more than 100 investors. In calculating the total number of investors in an art fund, there are certain “look-through” rules that must be considered. For example, entities formed for the purpose of investing in the art fund are not counted as a single investor but rather all of such entity’s beneficial owners are to be included in the aggregate investor count.

Section 3(c)(7) of the 40 Act, when read in conjunction with Section 12(g) of the Securities Exchange Act of 1934, provides that an art fund is not subject to regulation under the 40 Act if the total investors in such fund are less than 500 and all such investors are “qualified purchasers”, defined generally as natural persons with at least $5 million in investments, institutional investors with $25 million or more in investments (or that are owned entirely by qualified purchasers) and certain knowledgeable employees of the art fund or its advisor.

Unlike mutual funds and other regulated investment vehicles, art funds are not restricted by contract or under law in their choice of investment strategies, and therefore they can and do employ a varied basket of investment strategies. As a result, it is important to understand the differences between the various strategies as each strategy or combination thereof have varying degrees of risks and rewards.

The major strategies typically utilized by art investment funds include traditional “buy and hold” strategies; “geographic arbitrage”, which aim to exploit differences in price realization for certain artists’ works in different geographic locations; “artwork driven” strategies, which seek to profit from issues impacting a specific artwork’s offered price (such as issues relating to its condition, provenance, title, etc.); “regional art” strategies, which concentrate on investing in art from a particular geographic region (i.e., Chinese art); “period strategies”, which focus on investing in a particular period of art (modern, contemporary, impressionist, etc.); “emerging artists” strategies, which center around the investment in artists that are not yet established and therefore have the potential for rapid price appreciation; “intrinsic value” strategies, which involve investing in works by artists perceived by the fund manager to be selling at deep discounts to their actual or potential value; “leveraging” strategies, which involve borrowing on the art held by the art fund and using such funds to acquire additional art expected to produce returns greater than the borrowing costs during the term of the loan; “distressed art” strategies, which focus on the acquisition of artworks at deep discounts from collectors facing bankruptcy or insolvency; “co-ownership” strategies, which involve the art fund acquiring works jointly with other third party investors to share the risk of a particular investment and provide for further diversification of the art fund’s investment portfolio; “showcasing” strategies, which seek to increase the value of the fund’s art portfolio by arranging for the placement of such works in important museum shows; “bulk buying” strategies, which involve buying large lots of art in order to attain better pricing and lower transaction costs; and “medium” strategies, which center on the investment in a single form of media of art (i.e. photography) for which the art fund manager has particular expertise and deal flow.

Most art fund managers employ a diversified investment approach using more than one strategy simultaneously to realize gains for the fund’s investors. In doing so, the art fund manager is able to overweight or underweight the fund’s various strategies to reflect trends in, and to capitalize on available opportunities within, the art market.

It is worth noting that many of the foregoing strategies are impacted by both the number of available artworks satisfying the investment criteria of the art fund and the amount of capital that an art fund is able to successfully employ before the returns to be made from a particular strategy diminish. Accordingly, many art funds seek to limit the amount of capital they will accept.

The last few years has seen a significant increase in the number of art investment funds that have launched or are in the process of being launched. Much of that growth is due to the increasing recognition by the investment community that (i) the art market continues to benefit from significant price appreciation, (ii) traditional investments in stocks and bonds over the last decade have generated, and many expect will continue to generate, poor investment returns, (iii) the ownership of art can serve as an inflationary hedge, especially in light of the inflationary monetary policies employed by many countries in response to the 2008 credit crisis and resulting recession, (iv) art funds can produce returns that have little or no correlation to those of more traditional stock and bond investments thereby helping to diversify the overall risk of an investment portfolio, and (v) the lack of regulation of the art market provides unique opportunities for arbitrage that can be exploited for the benefit of art fund investors. Moreover, as most art funds are structured so as to weight art fund managers’ compensation towards performance incentives that involve a significant sharing of the gains earned by the art fund between the fund’s managers and its investors, talented art market professionals are electing in growing numbers to form or work for art funds so as to share in compensatory arrangements that have the potential to greatly exceed those of traditional positions within the art world.

The art fund industry has grown significantly over the last ten years with an increasing number of art funds, managers and service providers participating in the industry. That being said, the reality is that art funds and the transactions that they conduct represent only a small part of the global art market and investment industry. It is estimated that there are currently less than 200 art investment funds in the world with less than $3 billion in aggregate art investments made over the course of staggered investment periods of between three and five years. By way of comparison, the entire value of the sales of art conducted solely by means of public auction in 2009 was $5.14 billion, which represents only a small fraction of the aggregate global sales of art made in such year (estimated to be about $30 billion). In addition, there are over 9,000 hedge funds in existence worldwide with assets under management of over $1.7 trillion.

While certain (but not all) art funds do employ leverage strategies as one of the methods by which they expect to generate their desired investment returns, they typically do so using art value-to-loan leverage ratios of less than 1 to 0.5. Such low value-to-loan ratios are the result of the strict requirements of art financiers predicated by the lack of familiarity of lenders with art as a source of collateral and the inherent illiquid nature of art works in general. By comparison, balance sheet ratios of commercial banks and investment banks invested in more established classes of investments prior to the 2008 economic crisis were in some cases as high as 10 to 1 and 20 to 1, respectively.

Put simply, the use of leverage by some art funds should not in and of itself be a cause for alarm to the art market, art fund investors or the financial system.

Art funds provide a number of benefits to both the art market and investors. By raising money from investors who are not currently art collectors, art funds bring new money into the art market which provides additional liquidity to the art market, which helps to both foster continued price appreciation in the market as well as stabilize the market in periods of severe economic downturns. For individual investors seeking to add art as a part of their investment portfolios, art funds afford such investors with the opportunity to pool their funds with other investors, thereby diversifying their art holdings, and to benefit from the expertise of art fund managers who understand how to operate in what is generally known as a non-transparent, illiquid and unregulated industry.

While art funds are private investment vehicles that operate out of the public eye, art funds are still subject to regulation in a number of ways. The following general discussion relates to those funds seeking to raise capital from U.S. sources. Offshore art funds with non-U.S. investors are subject to different regulatory regimes depending upon their and their investors’ location.

• Registration of Art Fund Managers. The Investment Advisers Act of 1940 requires that persons who give investment advice relating to securities for compensation to U.S. clients must register as an investment adviser with the U.S. Securities and Exchange Commission (the “SEC”) if it does not meet certain exemptions promulgated under the recently adopted Dodd-Frank Wall Street Reform and Consumer Protection Act. As a practical matter, the Advisers Act generally does not apply to art funds unless they engage in significant leveraging and securities trading strategies. In addition, art funds today rarely exceed the newly adopted “assets under management” threshold of over US$150,000,000, after which registration with the SEC is required for private fund managers. However, to the extent that a particular art fund management enterprise produces significant and consistent returns, it is not inconceivable that such entity could attract significant investment in excess of the available thresholds for exemption so as to require registration. Art funds with less than $150 million of assets under management may still be required to register pursuant to the laws of the states in which they maintain offices or raise money from investors. The registration of an art fund manager as an investment adviser brings certain advantages from a marketing standpoint as many pension funds, family offices and institutions take comfort from the fact that the art fund manager is regulated by the SEC but it also bring disadvantages in the form of regulatory compliance and restrictions on charging performance based fees to certain “qualified clients”. It is worth noting that registered art fund managers are subject to stringent record-keeping rules promulgated by the SEC as well as periodic SEC examinations looking into, among other things, charged performance fees and conflicts of interest disclosures.
• Avoidance of registration of the Art Fund itself. The 40 Act requires that investment companies, another word for a mutual fund, register as such with the SEC and comply with the burdensome set of rules relating thereto. To avoid being characterized as an investment company, art funds must comply with the two established exceptions – namely have less than 100 investors in the art fund or up to 499 investors that are all “qualified purchasers”.
• Avoidance of registration of the Art Fund’s equity interests. In order to avoid registering an art fund’s securities with the SEC as an initial public offering pursuant to the Securities Act of 1933 (which is rarely advisable), an art fund must offer their securities privately pursuant to a Reg D private placement. To satisfy the private placement exemption, the art fund must limit its offering to “accredited investors”, make full and fair disclosures of all material elements of the investment in the art fund by way of a private placement memorandum and subscription agreements and file a notice with the SEC and “blue sky” notices with applicable state securities regulators that sales of the art fund’s equity interests are being made in reliance on Reg. D.
• Compliance with Anti-Fraud Regulations. Art funds and their managers are subject to the anti-fraud provisions of the Securities Act of 1933, the Securities Exchange Act of 1934 and the Advisers Act which prohibit fraud in connection with the offer and sale of the art fund’s equity interests and in connection with the advisory relationship. In addition, as a purchaser and seller of artwork within the United States, the art fund may be subject to various state laws specifically prohibiting the commission of fraud in connection with the sale of art by the art fund.
• Compliance with ERISA. The Employee Retirement Income Security Act of 1974 (“ERISA”) regulates the investment by pension funds in art investment funds by way of its “plan asset” rule. In essence, an art fund accepting 25% or more of its investments from benefit plan investors (such as ERISA investors and IRAs) are subject to various Department of Labor rules that in most instances an art fund would not wish to be subject to. Such rules include limits on investor lock-ups, valuation procedures for the fund’s assets and indemnification requirements. It is worth noting that self-directed IRAs are prohibited from investing in art funds.

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