Background
Following the emergence of art being used as a method of hedging conventional investment portfolios in the recessionary and inflationary years of the 1970s, art slowly became a more established and accepted investment asset amongst retail and institutional investors alike. As a consequence, during the art boom of the 1980s, lenders developed debt products to allow their clients (both art investors and art dealers) to borrow against artworks held in their collections or trading inventory, or against new artworks being acquired (as an investment or as new stock). Fast forward to the present day, the art finance market has grown significantly, particularly in the major global art markets and the key art trading centres of New York and London. Since its inception, art finance has become more formalised and sophisticated as a result of market fluctuations, and art lenders now include banks, debt funds, specialist lenders and auction houses offering a range of financial products to high-net worth individuals ("HNWIs") and gallery owners, including bridging finance to HNWIs.
Art finance – the benefits
The benefits of art finance to borrowers (usually HNWIs) are similar to those of bridging facilities generally, including:
- quick execution and funding;
- freedom of use of funds;
- reduced scope of due diligence; and
- flexible terms and structures.
An art backed loan may benefit borrowers who are "art rich" but "cash poor" by providing necessary liquidity secured on an artwork or a collection of artworks for specific purposes (such as paying a margin call on an equities portfolio or paying inheritance tax on a deceased individual's estate) as well as borrowers looking to monetise their art collections in order to make further investments (in art or otherwise).
The term and repayment structure of art loans tend to be bespoke and will vary depending on the needs of the relevant borrower and the relevant lender's credit criteria. That said, terms are usually for an initial period of between six months and two years, and common repayment structures include bullet repayments at the end of the term (in which case any interest will be capitalised and added to the principal amount of the loan), interest only (in which case interest will be paid periodically and the principal amount of the loan will be repaid at the end of the term) or amortising (in which case interest and principal will be paid periodically throughout the term).
Key points to consider:
- Loan to value
- Recourse/non-recourse
- Possession
Loan to value
As with other forms of finance, in art finance, a loan to value calculation is used to size the principal amount of the loan as a percentage of the value of the artwork(s) being used as collateral. In the majority of cases, to assess an artwork's value, lenders assess what a willing buyer would pay to a willing seller in an open market. This is known as a fair market valuation ("FMV"), which is undertaken by qualified and experienced art appraisers who also confirm the authenticity of artwork(s). Factors taken into consideration by FMV art appraisers include:
- provenance (i.e. the ownership and exhibition history of an artwork);
- sales history and track record;
- marketability (e.g. the artist's reputation/liquidity and the desirability of the artwork including its subject matter); and
- condition.
On a single artwork basis, the loan to value limit in conventional art finance transactions does not usually exceed 50 per cent.
Recourse or non-recourse
Broadly, there are two types of art financing arrangements; recourse and non-recourse loans. Both recourse and nonrecourse loans are secured against a borrower's artwork(s). However, whereas under a non-recourse loan a lender's collateral is limited to the artwork(s) over which it has security (i.e. not the borrower's other assets), under a recourse loan, such loan is also guaranteed by the relevant borrower (and therefore its other assets). Recourse lenders therefore take into account a borrower's creditworthiness as well as the FMV of any relevant artwork(s) in assessing whether or not to make a loan. As a non-recourse lender will not have the benefit of a borrower's credit covenant if a default under the art loan occurs, non-recourse loans are generally more costly when compared with recourse loans in order to reflect the higher credit risks to lenders in non-recourse lending.
Possession
Given the movable nature of artwork(s) and risks associated with unauthorised disposal or damage, particularly if the financing is on a non-recourse basis, most lenders require physical possession of the artwork(s) being provided as collateral. Therefore, as a condition precedent to a loan being made available, lenders (other than in the United States in certain circumstances) will require artwork(s) that are subject to security to be transferred to secure third-party fine art warehouses (located in various jurisdictions including the United Kingdom, Switzerland, Hong Kong and the United States) in order to perfect their security.
It is, however, quite usual for artwork(s) being used by HNWI as collateral to already be situated in a third-party storage location (such as a fine art warehouse, freeport, museum exhibition or gallery). Therefore, provided that such a location has the necessary facilities and expertise to safely and securely store the artwork(s), lenders may agree for the artwork(s) to remain in situ if the third party enters into a tripartite agreement with the relevant borrower and lender acknowledging and agreeing that such lender can (and is authorised by the borrower to) take possession of the artwork(s) should the relevant borrower default on the loan.
Conclusion
Given the potential value stored in fine art, the speed at which funding can be provided and the flexibility of the loan conditions available, HNWIs are increasingly looking at their art collections as an alternative source of liquidity and capital though art finance arrangements.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.