Friday, 21 November 2014

Demystifying Guarantees

Picture: UK Auction News
Guarantees have featured in big art auctions for a long time now, but recently they're a staple of market reports too. A lot of people suspect there's something untoward going on, and a recent FT article by Bendor Grosvenor prompted a response from Marion Maneker calling him splenetic and ill-informed, and a lively Twitter debate ensued. I think Maneker is right to criticise the FT piece for assuming that contemporary art is judged only on price; I have never seen it argued that art's good because it's expensive (instead we get all the guff that Bendor Grosvenor more astutely criticises). I find the prices paid for contemporary art inexplicable. Much is intrinsically unappealing to me, but even things that I like seem to be insanely out of line with good old masters that are as cheap as chips. But those prices can't be explained away as clever market manipulation. 

The main objection to guarantees is that they distort the market. Some buyers actually pay less than the reported sale price because they have provided a guarantee in return for a fee from the auction house that can net against the purchase price, if they buy the guaranteed lot. But this isn't simply a discount given to favoured clients (although I understand that some clients have enjoyed discounts on buyers' premiums - an issue that receives less attention than guarantees). It is a fee earned because the guarantors assume a real financial risk on behalf of the auctioneer, and give up the chance to buy the lot more cheaply after the sale if it fails to sell. There really are two legitimate nettable transactions here.

The fee is likely to be a proportion of the buyer's premium. A reasonable assumption is that the guarantee will be equal to the reserve hammer price. On top lots it's possible that sellers will get a portion of the buyer's premium as well as a guarantee, but I suspect usually sellers receive either a guarantee or a cut of the premium. So the premium must usually be shared between the guarantor and the auctioneer, which seems reasonable as each is providing part of the service - a financial guarantee plus the potential upside from a well-marketed auction sale.  

I agree with Bendor Grosvenor that guarantees mean that reported prices are unreliable, but I think that unreliability is more marginal than some critics realise. Only a minority of lots are guaranteed, and many of those sell to parties other than the guarantor. Of the remainder, the difference between reported price and price paid is unlikely to be substantial. You could argue that it's not a real price because they otherwise wouldn't have sold at all, assuming the guarantor would be unwilling to pay the 'real' reserve, but  a sale is a sale. No auction result is a reliable indication of how well a similar work will do next time; plenty of lots are bought by dealers only to remain unsold for years, or offloaded at a loss. Part of the criticism of guarantees arises from a misplaced belief in objective prices and a mistaken analogy between works of art and traded financial instruments.

Even if you think prices are manipulated at the margins, how many guarantees are actually underwritten by third parties? John Gapper reported in the FT that only $65m of $279m of guarantees were underwitten at Sotheby's. Christie's is privately held and doesn't disclose, but I suspect they take a much greater level of principal risk because they have to be bolder and take more risk to maintain their leading market position ($1.4bn vs $2.5bn over the last four NY contemporary sales, reports AHN).

So the most notable aspect of guarantees isn't their impact on reported prices, but their impact on the risk profile of the auction houses. Given their fairly thin capitalisation, they are very exposed to the risk of falling prices. Guaranteed lots are concentrated in a few high-profile sales. If just one sale tanks, they could face a huge loss. On that basis I'm not convinced that Christie's is really beating Sotheby's. They are certainly selling a lot more contemporary art, but probably with low margins and high risk. Sotheby's has been under pressure from activist investors to compete more aggressively, and they have just announced that their CEO is stepping down just after another drubbing in the contemporary sales (coincidentally, of course). But growing their market share won't necessarily boost returns on a risk-adjusted basis. Christie's can afford to behave like a hedge fund because it's underwritten by a billionaire private owner, but Sotheby's has a duty to its shareholders and must carefully assess the potential returns against the riskiness of guarantees. Art market downturns are even less predictable than financial crashes, but it is a cyclical market.

The final question is whether it matters. Two main reasons to regulate markets are to ensure market efficiency, which promotes optimal allocation of capital, and to protect consumers. The former shouldn't be an issue in the transactional art market. Art is a consumption good, even if some people speculate on prices (foolishly in my view). Indeed, there is some public interest in discouraging speculation in art because it diverts capital away from productive investment. Consumer protection is a valid concern, but guaranteed lots are already flagged in catalogues. I'm not convinced that the minor distortions justify further disclosure, or legislative clampdown that would hurt sellers and restrict market freedom. Art is inherently illiquid, prices for individual pieces are very volatile and a good deal of price setting occurs between dealers and their clients. A degree of caveat emptor may reasonably be required here. 

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