My last post discussed the liquidity everywhere phenomenon and how this has produced bubbles in everything from crypto to high yield bonds. The toughest nut to crack for small time investors remains highly illiquid investments that lock up your cash for long periods of time. Private equity, exotic cars, art and direct real estate have remained in the realm of “accredited” investors. It’s literally illegal for poor people to pool their money and invest in these types of assets because the government has deemed them so risky that they have to protect the little guy from them.

I won’t get into a debate on what the government should and shouldn’t tell you to do with your money but this hasn’t stopped entrepreneurs and the recent movement of crowdfunding from trying to exploit some new and unique loopholes in an attempt to aggregate small investor cash towards these investments. There are a dizzying array of startups that have tried to fill this niche. I highlighted some of them like Yieldstreet and Cadre on my last post but today I want to take the time to review one that focuses specifically on high priced art, a market for the ultra wealthy that has essentially remained out of the hands of small investors.

An Overview of Masterworks

The company was founded in 2017 by tech entrepreneur, investor and art collector Scott Lynn. Masterworks bills itself as the only company that allows small investors to invest in fine art. As far as I can tell, this still seems to be the case as I didn’t find any direct competitors. They claim that they invest in only “blue chip” art, a term I only found to be used by the company alone. As far as I can tell from my research, blue chip means artwork which is worth $500,000 or more. This is an important point which distinguishes the offering that I will get into later.

Masterworks claims that they can achieve returns for investors between 10% and 30%. This figure is based on past price appreciations of fine art. Their estimations are created by a team of analysts overseen by the CFO Nigel Glenday which seem to examine past data project a return out into the future. The company has also hired Masha Golovina who has experience at auction house Christie’s to oversee acquisitions.

The company targets high priced art made by well known names. Think Banksy, Warhol and Basquiat. They think that these pieces of art have the best chance of seeing price appreciation. The company purchases a work of art with it’s own cash (or that of its founder, we can’t be quite sure since it’s a private company) and then sells an ownership stake in the artwork to investors. This ownership stake is divided up into shares through what is called a Reg A+ offering. The investor funds then make Masterworks whole from their original purchase.

This type of offering, sometimes called a “mini IPO” is available to retail investors and capped at a total amount of $50 million. You can read more about the details here. The only stipulations are that a Reg A+ company cannot be a registered investment company, a business development company or a blank check company (SPAC). Masterworks creates a Delaware LLC framework for investors to place their cash in, they then are issued shares of the LLC. The LLC then purchases the artwork and a board of managers appointed by each LLC is in charge of overseeing the storage and eventual sale of the artwork. The board consists of executives of Masterworks as well as an independent director.

The painting, and as far as I can tell it’s been only paintings thus far, is then held for a period of anywhere from 3-7 years and is then sold on to a buyer. In order to avoid the hefty auction fees that one of the fine art auction houses may charge, a private sale is the company’s preferred method of exiting a work of art. Costs of acquisition, storage, transportation and sale are deducted from gross proceeds of the sale and then the fees for Masterworks come in. The company says their administrative fee is similar to that of a hedge fund. The company charges 1.5% annually on an accrual basis and then 20% on the net profit for investors. They aim to offer a few new works every month for investors.

To summarize:

• Masterworks purchases fine art which it then securitizes through a Reg A+ offering to retail investors.
• Art is then stored for a period of 3-7 years in the hope that it will appreciate in value. To keep costs low it is preferably sold to a private investor.
• Fees are 1.5% annually and 20% of net profits for the shareholders.
• The company claims that returns may be anywhere from 10% to 30% on an annual basis and offer a low correlation to traditional assets like stocks and bonds.

The Advantages

Before getting into the risks of an investment like this and some of the potential downsides, it’s worth looking at the advantages.

The first is that I think this is a good story of the broader trend of the democratization of finance. It’s simply not fair that potentially higher returning investments are out of the reach of normal every day people. The company makes many disclaimers that it does not not cannot guaranty any return on your investment and your investment may lose value. Although this was a niche portion of the larger art market, it was nonetheless one was closed to people unless they had tens of millions to spend on art.

I think the company did the right thing by focussing on the high end of the market too. In a Citi report found on Masterwork’s website for which they provided much of the data, for the period of 1985 to 2020, art as a whole offered similar returns to high yield debt at 8.3% annually, but contemporary art returned 11.5%, higher than all the categories Citi examined barring private equity. It seems there may be a case for investors to be able to access this space and see some compelling returns.

Citi also provided a matrix showing art’s correlation with other assets over the same period. There is a strong case by correlation here for some allocation. Art as a whole offered the lowest correlation to all the asset classes shown. From stocks to bonds to cash, art consistently had the lowest correlation across the asset classes over the time period examined.

To summarize:

• Masterworks focuses on a particular niche of the art market: highly priced prices by well known artists.
• There is some evidence that this market offers competitive returns over time compared to other, more traditional asset classes.
• The observed correlation of art is very low compared to other assets which is a good case for using this potential asset class as part of a diversified portfolio.

The company does seem to take care that they have proper investment screening as well. An “interview” that was set up via phone with me after signing up online was really a screening call. The Masterworks employee asked about my net worth and my motivations for trying the service. The seemed knowledgeable and was able to answer my detailed questions on the offering. It’s comforting to see that they don’t look at their business model as another fad and would like to attract sophisticated and long term investors.

The Risks

There are a number of risks that should be considered when investing in this niche market and a number of things I questioned after doing my research on the company. Some of them are mundane and others you may want to think about before investing yourself.

• Survivorship Bias – Although the past returns look great, they can easily be manipulated to look great and investors have to cast a careful eye towards these things. An example comes from another art price aggregator called Artprice 100. They look at the top 100 best selling painters of the past 5 years which have 10 works or more sold each year. This specific segment of the market does seem to outperform equities but overall art seems to underperform equities.

• Fees – Fees are a killer and there is a reason many large pension systems have dropped hedge funds in recent years: the fees don’t justify the net return. For example let’s say a price made a 16% return annually over 5 years, the midpoint of their 5-7 year timeline. Besides transport, storage and selling costs, which we won’t know what they will be, the 1.5% annual fee will take 7.7% right off the top. Add to that the 20% of profit if we assume no other costs and the fees have been knocked down to 12.7% annually. That headline return isn’t looking so sexy now given that the Vanguard Total Stock Market ETF (VTI) itself has returned 16.72% annually over the past 5 years. If we count additional fees, these assets may have to return anywhere from 3-4% above market annually just to match the historical market return of around 10% for equities.
• Illiquidity – There is a small buyers market for these works. If that market shifts or tastes change, investors could be left holding the bag. I think this is less of a risk for well known artists over a period of 3-7 years but who knows what could happen? Any famous figure could be a racist quote or a “Me Too” revelation from public shaming and abandonment of their work. Artists are known for their quirky and offbeat lifestyles but public scorn is not beyond them either.

There is also the point that these works are kept in storage. It seems a shame and a bit ironic that such an esteemed piece of art would just be left to hang where no one could see it. Although a price of work itself does not produce income, it seems that leasing it during the ownership period to an art museum or gallery could potentially add an income stream for investors as well. This is not currently an option for investors.

All in all, there may be some good reasons to try Masterworks if you are looking to diversify your portfolio into a niche illiquid market. Just be aware of the risks before doing so. For once the little guy has a chance to profit from fine art just like the whales.

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