The Resurgence of Art Funds —Turning a Passion into Investment Returns

Investing in alternative assets such as art and gold during times of inflationary pressure and turmoil in the financial markets is nothing new. Recently, however, the prevalence of so-called “passion investments” has increased, with art funds emerging as an attractive alternative investment. This article explains how art funds work and sets forth important things to consider before investing in an art fund.

What Is an Art Fund?

An art fund is generally a privately offered investment fund that is managed by a professional investment manager. Such funds may be organized either in the United States or as an offshore vehicle, depending on where the fund’s prospective investors reside. In the United States, art funds are typically structured as “closed-end funds,” more commonly known as private equity wcharacteristics of a private equity fund are: (1) a fixed life, usually five to ten years, with the option of a limited number of oneyear extensions to permit the orderly liquidation of assets; (2) investments by limited partners of a fixed amount, called a “capital commitment,” that the investment manager “draws down” from time to time over the fund’s life to pay for the fund’s investments, fees, and expenses; and (3) limitations on investor withdrawals, except in extraordinary circumstances, prior to the end of a fund’s life.

What makes a private equity fund an “art fund” is its strategy. Some art funds pursue a focused investment strategy (e.g., Old Masters or Chinese Imperial porcelain), while others seek a more diversified portfolio of artworks. While the individual strategies of art funds differ widely, at a basic level all art funds seek to generate financial gains through the acquisition and disposition of artworks.

What Are the Costs?

In consideration of its services, a private equity fund’s investment manager (or an affiliate that acts as the fund’s general partner) typically receives a management fee of 1.5% to 2% of the total amount of capital that the investors have committed to the fund. These management fees pay for expenses related to the manager’s overhead and personnel costs. In addition, the fund’s investment manager receives a share of the fund’s net profits derived from the sale or other disposition of the fund’s investments, which is typically 20%, with the remaining profits paid out to the fund’s investors. Some funds require that investors receive a minimum rate of return, typically 8% to 12%, before the fund’s investment manager receives its share of the profits. In private equity fund parlance, this is called a “preferred return.”

In the art fund context, fee terms are substantially similar to those of other types of private equity funds. Some art funds, however, separate the capital commitments made by fund investors into “investment commitments” and “expense commitments.” The former is the total amount an investor will invest into the fund for purposes of acquiring artworks. The latter is an open-ended commitment by an investor to pay his or her pro rata share of fund operating expenses over the life of the fund, including the management fee paid to the fund’s investment manager. This fee structure reflects the unique operating expenses incurred by an art fund, including the cost of storing, transporting, appraising, and insuring artworks.

Another unique expense associated with art funds is fees paid to art advisors, who offer their expertise in connection with the purchase and sale of artworks. These additional carrying costs and expert expenses are not typically associated with other types of private equity funds and can lead to specialized provisions (e.g., separate expense commitments and more frequent capital calls) in art fund documents. In addition, by separating investment and expense commitments, an art fund’s investment manager is better able to determine how much investor capital is available to acquire artworks for the fund’s portfolio.

Art Funds vs. Collecting

Investing in an art fund, as opposed to building a personal art collection, provides certain benefits. By pooling together many individual investments, an art fund benefits from economies of scale unattainable to most individual art collectors. More specifically, an art fund can invest in a greater number of artworks than a typical art collector can invest in, while also offering investment diversification at a much lower cost. This scale also gives an art fund greater negotiating power than the typical art collector has. Art funds may also reduce the transaction costs paid by art collectors in connection with the purchase and sale of artworks. These costs include the buyer’s “premium” and the seller’s “commission” paid to auction houses and galleries. By relying on its art advisors, an art fund seeks to reduce or even eliminate these transaction costs, thereby increasing the potential investment returns for investors.

Where Is the Art?

Another unique feature of art funds relates to how the artworks (i.e., the fund’s assets) are held. To enhance the provenance of the artworks, most art funds lend their artworks to museums, galleries, and other art institutions. Some art funds lend their artworks to their investors, thereby allowing investors to benefit not only from potential investment returns, but also from displaying the artworks in their homes. In effect, these investors gain personal access to artworks worth much more than their investment in the art fund. But, given the insurance and other risks such loans pose, many art funds do not allow investors to borrow works; instead, they store works in reputable art storage facilities when the works are not on loan to museums.

Tax Considerations [1]

It is also important to note the potential tax issues raised by an investment in an art fund. As a general matter, each limited partner of an art fund is required to report separately on his or her tax return his or her allocable share of the fund’s net long-term capital gain or loss, net short term capital gain or loss, net ordinary income, deductions, and credits. Due to the unique nature of an art fund’s strategy, there is some uncertainty as to the tax treatment of income or gain derived from the disposition of artworks that is allocated to a fund’s limited partners. In particular, the tax treatment differs depending on whether the Internal Revenue Service or a court of law would consider the artworks as “stock in trade,” or alternatively as “capital assets.” [2]

This determination is a question of fact, and how the Internal Revenue Service or a court of law would interpret these facts cannot presently be determined with certainty. These issues are of particular importance to tax-exempt investors and non-U.S. investors. Any fund investor, however, would be well advised to review these tax issues with his or her fund manager prior to investing.

Conclusion

Art funds have recently reemerged as an attractive alternative investment that may serve as a hedge against inflation and a source of returns uncorrelated to the general equity and debt markets. An art fund seeks to wield its size to acquire a diversified portfolio of artworks at prices generally unattainable by individual investors. But, unlike other tangible assets held by many other types of private investment funds, art has no inherent value and, indeed, its valuation is highly subjective. Further, the art market can be extremely volatile with no certainty of liquidity. Thus, art funds rely on professional investment managers and art advisors to implement their strategies and realize investment returns. In light of the risks involved, it is important to consult with a professional advisor before investing in an art fund.