The following article on family offices and art investments is by Randall Willette, who is managing director, Fine Art Wealth Management, a specialist firm in the sector.

The following article on family offices and art investments is by Randall Willette, who is managing director, Fine Art Wealth Management, a specialist firm in the sector. He is also a member of the editorial advisory board of this publication and has written several articles about these issues in recent years.

Recent trends point toward increased and continued exposure to direct investments in art particularly among family offices.  Since 2009, family offices have become significantly more interested in making direct investments following the profound impact of the economic crisis.  According to studies carried out by Wharton Family Office Alliance, a unit of the University of Pennsylvania's Wharton School in Philadelphia that focuses on wealthy families and their businesses, families have almost doubled their investment allocations to direct investments in companies and property.

More recently, this trend has extended to  art supported by the latest Art & Finance Report just released by Deloitte/ArtTactic. In a survey of wealth management professionals 53 per cent stated that the challenging economic environment has been the main motivation for their clients to include art in their overall wealth portfolio in 2012 (up from 28 per cent in 2011).  A large majority (60 per cent) of wealth managers believe this trend will continue even stronger in the future.

What's driving this movement?

Historically, single and multi-family offices hired asset managers to help allocate capital in order to preserve wealth for future generations. The majority of this capital was traditionally placed into the hands of asset managers that focused on conservative holdings. At the same time, however, almost every family office maintains a smaller pool of capital for riskier assets. In the past, this capital was placed into higher-risk vehicles like hedge funds, private equity funds and more recently art investment funds with the hope of achieving higher returns. 

However, increasingly the trend in family offices seems to be heading down the path of direct investment. These trends are a result of deep concerns over transparency and poor performance of fund managers in general. For art funds specifically, the difficulty in assessing their viability, small size and relatively flat growth, and lack of track record have also been major obstacles according to the Deloitte/ArtTactic report. 

The rate of direct investment is increasing as family offices start to look more and more like private equity, venture capital, and hedge funds. What's compelling is that family offices do not have to pay the "2 & 20" typically garnered by art fund managers. Along with paying management and performance fees, investors in art funds may also be required to commit their money for long periods of time. All this suggests a trend that has momentum and may have profound effects on the art fund space over the coming years.

Motivations of direct investment in art?

The decision to invest directly stems from a combination of emotional and financial motivations. To date, research on the direct investment asset class has largely considered only economic motives, excluding non-financial concerns. Yet, many investors are motivated by a variety of emotional rationales, particularly when considering direct investments in art. These reasons include the desire to:  preserve control and remain active; educate family members; achieve social impact; and secure wealth across generations.

Preserve control

Direct investment in art is for family offices that have a strategy to be active and have a high level of control over the underlying investment - in essence for those who want to physically own the art. An art investor can take part in/control key decision-making, in particular the exit.  The issue with direct investing is the degree and length of commitment that is required, which means the family office must have an internal team or outsource to art market professionals. Without this a family office cannot successfully source, execute, and monitor an art investment portfolio. 

The benefit of hiring a team is you can craft and control it, however the challenge is attracting and retaining expensive talent and ongoing costs.  A family office must use the expertise of internal and external teams to assess economic conditions, financial and art market dynamics, and other variables it believes may influence the prices, activity, availability of supply, and future attractiveness of opportunities identified for investment. 

These opportunities are generated by the underlying dynamic of the art market which is inefficient, illiquid, lacks price transparency and has highly differentiated products. Similar to private equity, a family office must not only engage in the right transaction at the right time and at the right price, but it must also enhance the value of each artwork through a variety of curatorial and marketing activities commonly practiced by successful collectors and dealers.

Social impact

Investing directly in art also provides a greater opportunity for collecting families to maximise social impact. The line between for-profit businesses and philanthropy has been blurring as social impact investments have shown that a financially sustainable business model can achieve far greater impact than charity, given its ability to scale.  Today, the private collections of ultra high net worth families can rival those of major art institutions and by joining forces an extended family unit can make a significant social impact.   Private museums are being created at an outstanding rate, and for many collecting families giving has become synonymous with investing as families seek to give back to their communities by sharing their passion for art with the public. 

Families with exceptional art wealth are moving toward an increased focus on using their collections and their wealth to realise what they define as a richer life and to achieve a greater sense of fulfilment for themselves and for their community.  With their collections as their core, and with their missions of civic responsibility and building community, collecting families can make a meaningful contribution to the preservation of cultural heritage and diversity. 

Professional development 

Direct investment in art and art related businesses can provide opportunities for professional development and knowledge of the global art market for family members and to pass down an understanding of the family collection that future generations can benefit from. Dealing professionally with art requires time and considerable knowledge. Obtaining recognition as an art expert generally requires intense study whether theoretical, academic or practical. Even the most experienced collecting families can benefit from professional guidance in today's fast paced and complex art market.

Scope for unmatched financial returns in the art market

Finally, and certainly not least, direct investments in art and art related businesses allow scope for unmatched financial return.  For the already well-established, this economic motivation is clearly rooted in the desire to achieve family wealth sustainability.  For example, family offices can obtain high potential returns by responding to the shortage of capital in the art market, and actively deploying capital in art financing transactions. 

Family offices can provide art dealers, auction houses, and other market entities with the resources necessary to make timely investments where traditional banks, unfamiliar with art world practices and dynamics, impose prohibitive terms. In exchange for providing financing to these groups, family offices can enjoy a share of the financial upside of these transactions. In the future we may expect to see more family offices invest in art-related businesses, commission works of art, or provide backing for commissions in conjunction with galleries, dealers, and institutions and the artists themselves, in exchange for participation in future profits from sales.

Co-investment

Family offices with particular expertise in sectors of the art market are also increasingly seeking to collaborate with others to leverage the investment opportunities they identify. The attraction of co-investment opportunities include the fact that the family office typically has significant “skin in the game,” a demonstrated expertise, and the ability to add value beyond capital (eg, via business skills, art expertise, proprietary deal flow, or art market intelligence).

We foresee a steady rise in shared due diligence and co-investments in art among family offices, facilitated by increasingly formalised structures that will fall into two broad categories. 

Buying art works in partnership with art dealers

While a family office will generally acquire direct ownership of an art work, in certain circumstances it may own an art work in partnership with an art dealer. A family office may also enter into arrangements with selected dealers to share in the potential upside of a painting by receiving remuneration at such time the painting is sold.  The family office may also seek to take advantage of current market conditions and perceived inefficiencies by purchasing and selling certain art works within short periods of time.

Co-investment with Auction Houses

Family offices may also seek higher returns by selectively deploying capital to the auction houses and by participating in guarantees extended by the auction houses to a select number of important sellers of art works on pre-agreed terms and conditions. In exchange for participating in guarantees with auction houses family offices will enjoy a share of the financial upside or downside of these transactions.

Conclusion

Direct investment is a documented trend among family offices that is picking up traction and may be ready to emerge full-force in the art market in the near term.  Due to the nature of family offices, this is particularly interesting for a market actively seeking to raise capital.  Unlike private equity firms, family offices can be very quick on their feet, are flexible, and that flexibility can translate to opportunistic investment in art and art-related businesses. 

While the growing interest in direct deals from family investors is understandable, we would also counsel caution. Those wishing to invest directly in art should consider whether they really have the expertise and the proprietary deal flow to compete effectively in the global art market.