Art Market
Why Guarantees Are Actually Good for the Art Market
Courtesy of Sotheby’s

Courtesy of Sotheby’s

Collectors are sometimes terrified to sell works of art at auction—and not without reason. Maybe the object will fail to sell, becoming tainted or “burned” in the eyes of the marketplace. Maybe the estimates the consignor agrees to are too low, and the work sells for a song. But selling at auction also exposes the work to the largest number of potential buyers, increasing the odds it will sell for the best price possible. Small wonder cognitive dissonance is a common affliction among auction consignors.
Auction houses have a solution for this dilemma: They provide a guarantee that the work will sell for a pre-specified minimum price, which they extend on their own (“house guarantee”) or in partnership with a collector, gallery, art advisor, or investor (“third party guarantee”). Guarantees have been an important part of the top end of the art market for decades. The famous Scull Collection sale at Sotheby’s in 1973, for example, involved a house guarantee while the first third-party guarantee is believed to have occurred in 1999 when Sotheby’s found a backer for a painting. But lesser known is that third-party guarantors now take on the vast majority of the risk, with auction houses simply structuring the transaction and selling off the risk.
According to data compiled by Lobus (an arts-related data and analytics company), Sotheby’s, Christie’s, and Phillips sold $922 million (hammer price plus reported buyer’s premium) of art this May in their post-war and contemporary evening auctions. About 50 percent of sale proceeds were from lots sold with some type of a guarantee. But instead of providing the guarantees themselves, the auction houses sold nearly all of it off to third parties—95 percent of these sale proceeds were associated with third-party guarantees. Just four years ago, according to the New York Times, only 40 percent of sale proceeds from guaranteed lots sold at Christie’s and Sotheby’s in their November post-war and contemporary evening sales had a third-party guarantee.    
Let’s take a look at how an auction house guarantees works, and how it benefits consignors. Then, let’s examine the recent sale of an painting for $157.2 million to highlight the substantial risks and benefits associated with being a third-party guarantor.

How an auction house guarantee works

Suppose a collector would like to sell a Picasso painting, but she wants to know with certainty that it will sell for a good price. After negotiating with multiple auction houses, she signs a consignment contract with the following terms:
  • Price guarantee of $10 million. This is the minimum amount of money the auction house guarantees it will remit to the seller after the auction. The consignor is entitled to this minimum price no matter what happens in the sale. The risk of the work selling is now transferred to the auction house.
  • 80/20 upside split. The painting will hopefully sell for a hammer price of more than $10 million. If it does, the upside split determines how this amount will be divided between the consignor and the auction house. In this deal, 80 percent of the upside goes to the consignor, with the remaining 20 percent going to the auction house.
  • $10–$12 million auction estimate. The auction house wants to communicate to potential bidders that it believes this Picasso painting will sell for a hammer price between $10 million and $12 million.
Let’s see what happens to the consignor and the auction house under three different hammer price scenarios:
  • $14 million hammer price. The consignor and auction house specialists are probably all wearing big smiles. The consignor gets $13.2 million for their Picasso, equal to the $10 million guarantee plus 80 percent of the $4 million upside. The auction house is also happy because they made $2,834,000 on the sale, equal to 20 percent of the upside ($800,000), plus $2,034,000 in buyer’s premium on the $14 million hammer price paid by the successful bidder (using Sotheby’s buyer’s premium schedule for New York in this particular example).
  • $10 million hammer price. The consignor and auction house probably feel okay, but not great, about what happened. The consignor gets the hammer price from the buyer, but no doubt she was hoping the painting would sell for more. The auction house makes $1,518,000 in buyer’s premium, but receives no upside.
  • Bidding stops at $9.5 million, just below the $10 million reserve price. The seller is probably thrilled they sold the painting with a guarantee because the auction house is obligated to pay them $10 million. But the auction house now has a financial problem on their hands, because they are out $10 million and own a painting that failed to sell.
When a consignor sells with a guarantee, they are effectively buying an insurance policy from the auction house. Because insurance is not free, the consignor pays for it in some way. In the case above, the “insurance premium” the consignor pays is equal to the potential upside split the auction house may retain. The insurance policy is also sometimes referred to as a “put option” because the consignor has the right to “put” the painting to the auction house for a minimum payment of $10 million. A guarantee on a painting is similar in many ways to a put option on a stock, and can be thought of as another type of financial derivative.

Third-party guarantees: The case of the $157 million Modigliani

Auction houses oftentimes do not want to hold the risk of a guarantee. For example, maybe they already have a Picasso with house guarantees, but there is another Picasso consignor also looking for a guarantee. The auction house may feel uncomfortable taking on additional financial risk associated with Picasso. So to win the consignment, they provide a guarantee, but then sell it off to a third-party before the auction takes place.
To entice third-parties to be guarantors, auction houses can offer them two things: a portion of the buyer’s premium that the auction house hopefully earns from the successful bidder, and a portion of the upside split that the auction house negotiates with the consignor. Depending on the auction house, the buyer’s premium payment may be referred to as a financing fee or fixed fee, while the upside split may be referred to as overage.
The amount of buyer’s premium and/or upside split that a third-party receives for being a guarantor is highly deal dependent. It will depend on their negotiating skills with the auction house, knowledge of the artist’s market, and willingness to own the object if bids fail to materialize on the night of the sale, among other factors.
Most third-party guarantors like to receive both a financing fee and some portion of the upside as compensation for the risk they take on. Using the Picasso example above, a third-party may be able to negotiate a financing fee of 4 percent of the guarantee amount (i.e. a $400,000 financing fee), plus 15 points of the 20-point upside split, the auction house negotiated with the consignor. If the painting sells for a hammer price of $14 million, then the guarantor will earn $1 million, equal to $600,000 of upside and $400,000 from the financing fee. But if the painting fails to sell, then they are effectively forced to buy the painting for $9.6 million, which is the guarantee amount they committed to less the $400,000 financing fee. As illustrated by these two potential payoffs, being a third-party guarantor is truly a high-risk/high-return proposition.
Let’s use the recent sale at Sotheby’s of a Modigliani painting with a third-party guarantee to trace through a specific case of what happened to a guarantor. Sotheby’s offered a magnificent reclining nude painting by Amedeo Modigliani this May. The largest in a series of 22 reclining nudes by the artist, it was prominently displayed in the recent Modigliani retrospective at the Tate Modern. The work had the highest pre-sale auction estimate ever placed on a single work of art: $150 million. Press reports indicated that the lot was guaranteed by Sotheby’s and a third-party for about the pre-sale estimate. Interestingly, another reclining nude painting from the series sold in November 2015 at Christie’s for $170.4 million.
In a surprising development, when the painting came up for sale, it sold on one bid to the third-party guarantor for a hammer price of $139 million, or $157.2 million with buyer’s premium. No other buyers expressed interest in the work that night. While details on the guarantee contract were not disclosed, the third-party guarantor received no payments whatsoever for taking on this huge risk. We know this because when a third-party guarantor buys a work, auction houses are now required by New York City’s Department of Consumer Affairs to report the sale price net of any fees received by the third-party guarantor. But the sale price reported by Sotheby’s was $157.2 million, so the third-party guarantor apparently did not negotiate a fixed fee into their contract; they must have been focused on negotiating a great upside split deal—but, because no other buyers wanted the painting that night, there was no upside split to earn. I have no knowledge whatsoever about the identity of the guarantor, so I can only speculate on their motives. My guess is that they believed the painting would sell for way above the guarantee amount, given that another painting in the series had sold two years before for $170.4 million.  
What market forces may have been behind the painting selling for less than expected? There are very few people in the world who have the means and desire to spend over $100 million on a work of art, so the pool of potential buyers for this Modigliani was already quite small. But two other reclining nude works from the same series of 22 paintings were widely rumored to have sold privately, shortly after the previous Modigliani reclining nude painting sold for $170.4 million in November 2015. As a result, three potential buyers in the already extremely small pool of people with the means and desire to spend over $100 million on a magnificent Modigliani were probably not interested in acquiring another one in May 2018.    
Doug Woodham is Managing Partner of Art Fiduciary Advisors, former President of Christie’s for the Americas, and author of Art Collecting Today: Market Insights for Everyone Passionate About Art.