Over the past decade or so a thriving business has developed aimed at putting “sleeping” assets to work. Many high net-worth individuals, businesses and institutions have art hanging on their walls – or worse yet, in storehouses – that are doing nothing but sitting pretty. This art, however, is an untapped asset that can be leveraged to provide financial liquidity without having to resort to sale.
There are many reasons to use art to generate liquidity. Besides the “three Ds” –debt, divorce and death – art can be used to finance further acquisitions, to provide operating cash or for general purposes. The loan can also be a bridge loan – providing liquidity while waiting for a sale of the art to occur.
The classic art loan is an “asset-backed loan”. Basically, the borrower is given a loan and posts the art as collateral to secure repayment. Of course, the process is more involved.
What follows is a description of a typical loan. Note that all terms are negotiable, and a potential borrower should always attempt to negotiate more favorable terms than are presented in the lender’s documentation!
There are main three actors: the borrower, the lender and an arranger.
The arranger scouts loans for the borrower and is paid a fee for the service, such as an up-front fee and a percentage of the loan and/or a percentage of any future sale proceeds (also known as a “success fee”). Often the arranger is affiliated with the lender; a potential borrower should be alert to this inherent conflict of interest, even though it is common in the industry.
Lenders can either be traditional banks, or private lenders or "non-bank banks". They obtain their capital by borrowing from other financial institutions or investors and make their money by the spread of the interest rate charged over the interest rate paid.
The lender “underwrites” the loan, meaning obtains appraisals of the art, confirms the provenance, and either arranges for insurance and the storage facilities for the art or confirms existing arrangements. These preliminary expenses are passed along to the borrower, together with legal costs, either by payment of a due diligence fee before the loan or as a deduction from the loan’s gross proceeds.
To secure the loan and the due diligence expenses, the art in the warehouse will be transferred into an account in the lender’s name and the lender will file UCC security interests with the state’s secretary of state. On occasion, an agreement will be reached to permit the artwork to stay in its present location – on the wall of the owner’s home, say – rather than be taken into custody;, the agreement can be documented by a simple letter or, sometimes, security devices will be affixed to the artwork to ensure that the lender is notified of any removal.
The loan will typically be a balloon loan, with interest payable at regular intervals and the principal payable upon maturity. The interest rate is often a floating rate keyed to 1-month LIBOR and is often very high, approaching that of a "hard money" loan. The first interest payment will often be subtracted from the gross loan proceeds; occasionally the parties agree to have all interest deducted at the outset.
The amount of the loan depends on the value of the artwork. The value used for lending, though, must be distinguished from the “fair market value” or the appraised value, both of which can be overstated for insurance. The value assigned to the artwork is usually the “minimum auction value”, the low end of the range the work could reasonably be expected to fetch at auction. The loan will then be a fraction of that value, typically 50% or less for blue-chip artwork.
Terms in the event of a default can be draconian. There may be a steep increase in the interest rate (“default interest”), an acceleration of the loan and, unless the default is cured, a sale of the collateral to satisfy all the outstanding obligations. The sale can be by auction or private sale, usually at the discretion of the lender.
The same principles are often used for loans against other luxury items, such as gemstones, luxury cars, yachts, etc., although each asset class presents specific issues. For example, the provenance of diamonds must be certified to be non-conflict; storage of cars is different than storage of artwork, and security interests in moving objects such as yachts can be challenging.
While none of the above is rocket science the details can be tricky and the documentation very involved. Experienced counsel can be of great assistance in exploring the available options and negotiating the commercial terms and documentation.
Jonathan S. Berck, LLC, stands ready to assist if you are considering an art loan.