Going Twice…

Out of necessity, the top auction houses are acquiring a new financial discipline.
Tony McAuleyMay 17, 2007

The top end of the auction world can be a rarefied place. Giving an investor presentation in New York in March, William Sheridan, the finance chief at auction house Sotheby’s, described how one of the company’s principal assets, and a significant barrier to entry for competitors, is “unparalleled access to the world’s wealthiest people.” Gesturing to a slide of recently published billionaire rich lists, Sheridan said, “My boss, Bill Ruprecht, has access to anyone on this list. We have what they want to buy — it’s a very unique access.”

The company’s connections can be deduced from its board, led by chairman Michael Sovern, former president of New York’s prestigious Columbia University who sat on the board of one of the Rockefeller family’s cultural funds. This month, Sotheby’s is expected to fetch in the neighborhood of $40 million (€29.5 million) for Mark Rothko’s “White Centre,” a consignment won from David Rockefeller. (On May 15, “White Center” sold to an unidentified bidder for $72.8 million, a record for a single postwar work of art.) Sotheby’s vice chairman, the Duke of Devonshire, last autumn hosted a Sotheby’s exhibition, including works by Damien Hirst and Henry Moore, at the family’s 35,000-acre Chatsworth House estate in England’s Peak District.

At the same time, auctioneering can be a very earthy business. In the March presentation, Sheridan went on to describe the “infamous four Ds” that drive art sale commissions: death, divorce, debt and discretion. “The head of our business development department loves sport,” Sheridan joked, “but now he reads the obituaries every morning instead of the sports pages.”

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It can also be downright grubby. The low point for the industry’s two dominant players — Sotheby’s and Christie’s between them share more than 90 percent of the fine art and luxury object auction market (2006 value = €6 billion) — was the price-fixing scandal and trial that unfolded in the US in 2000 and 2001, accompanied by a downturn in the art market after the dotcom crash and the September 11 terrorist attacks.

Auction House Cleaning

Even in the era of Enron, the corruption saga attracted more than its share of media attention, drawn by characters such as art world patrician Sir Anthony Tennant, then Christie’s chairman, who was indicted but refused to travel to the U.S. to answer charges; Christopher Davidge, the equally posh former CEO of Christie’s, who turned state’s evidence to the state in 1999 after making off with a $7 million severance package; Diana “DeDe” Brooks, Sotheby’s CEO at the time, a workaholic former banker who also testified for the state and received a six-month “home confinement” sentence and a $350,000 fine; and A. Alfred Taubman, a Midwestern property tycoon and Sotheby’s then chairman, who was fined $7 million and spent a year at the Federal Medical Centre (a prison) in Rochester, Minnesota, the only player in the drama to serve time behind bars.

At the time, the survival of the two houses, which trace their dominance of the auction world back to 18th-century London, was in question. But the recovery of Sotheby’s and Christie’s has been remarkable, helped by the strongest art market on record over the past two years. Also remarkable is the fact that the biggest loser of the episode was Phillips, the number three auction house that was acquired by Frenchman Bernard Arnault’s LVMH luxury group in 1999 with the intention of taking on the duopoly.

The scandal and its aftermath offer lessons about a number of fundamental business tenets: the strength of luxury brands; risk management in a cyclical business; the possibilities and limitations of technology, especially for top-end auction models in the age of eBay; and about managing a “talent-driven” business.

Sotheby’s experience has been the most visible, as a public company. As a first step towards recovery in 2002, and uniquely for managements of scandal-hit companies, Sheridan, CEO Ruprecht and five other key executives were offered a total of $9.5 million in “retention payments” plus other incentives to stay on and manage the firm out of crisis. The management team slashed headcount by 30 percent, costs by 19 percent, and reined in other projects. At the end of 2005, management also convinced the Taubman family to allow it to recapitalize the company (at a net cost of $10 million) in order to remove the A-B (10-to-1 vote) share structure by which they had retained control. “Our real concern was that [the Taubmans] could sell that controlling stake to another owner, which could disadvantage the rest of the shareholders,” Sheridan explains. Since then, Sotheby’s shares have soared, to $50 from around $20, outperforming the S&P 500 index by 40 percent.

The cost-cutting moves, meanwhile, gave the company “operational leverage,” says Sheridan. “We brought the breakeven way down and the business has benefited from that.” he says. In March, Sotheby’s reported record revenue of $665 million for 2006, on record auction sales of $3.8 billion, boosted by surging interest from emerging pockets of ultra-wealth, such as the anonymous Russian buyer said to have been behind the $95.2m purchase of Pablo Picasso’s “Dora Maar au Chat.” Illustrating Sheridan’s point about operational leverage, last year’s Ebitda was up 51 percent at $218 million.

La Belle Époque

Meanwhile Christie’s, which was taken private by French retailing billionaire and art collector François Pinault in 1999, used the crisis to change not only management personnel but the ethos at the top. After the departure of Davidge, one of a long list of Eton-educated toffs to run the house, Christie’s promoted the youthful US unit head, Edward Dolman (now 46), who had made his name by building up a younger clientele with auctions of pop and spy memorabilia. Last November, Dolman created a new CFO role and brought in Philip Anders, who had held the same job at United International Pictures in London.

As a private company, Christie’s doesn’t report operational results. But Anders says, “The ultimate measure of success is whether you are able to beat the competition, and as far as I’m concerned there was clear blue water between us and Sotheby’s last year — we were $1 billion ahead of them” in auction sales, at $4.7 billion. Sotheby’s counters that its rival maintains market share at the expense of profitability.

Perhaps a hangover from the price-fixing accusations, executives at the two big auctioneers now rarely miss an opportunity to emphasize how keenly they compete with one another. As they distance themselves from that episode (there remains only a liability of about $45 million each in “vendor coupons” that the victims in the antitrust suit can use over the next year), they are looking to do battle on several fronts.

Principal among these is extending their international reach and their brands. Both have found new offices in Moscow, Beijing and Dubai, and other locations in emerging markets. “These are not big fancy auction premises,” Sheridan explains. “They are one-to-two-people shops to really get to know the wealthy clientele in those marketplaces.” Economic and demographic trends — “a wall of wealth” — are driving the luxury auction market. “You just wonder, how good can it get?,” Sheridan says. “In the first quarter of 2007, auction sales for Sotheby’s were up over 50 percent, so that positive momentum brings discretionary sellers out on the supply side.”

The heat in the market is itself risky. “It’s a cyclical business, I’m not going to deny that,” Sheridan acknowledges. “But it’s a broader base now — we’re in over 70 categories and all of them are doing well. This provides a natural business hedge. [In addition,] we’ve built a lot more variability into our cost structure that we can dial back when the market does turn.”

Anders agrees that the art market has become broader and more sophisticated, making it less risky. “I think there have been changes that are permanent shifts,” he says. “The art market as a whole has seen some structural changes over the past few years. Art is less the domain of the elite few. As major economies have done incredibly well, a lot of very wealthy individuals have been created and they are increasingly sophisticated about art and other luxury objects, and increasingly better advised.”

As part of its expansion plans, Christie’s held its first auction in Dubai last May, achieving sales of $8 million. In the second sale this January, it sold more than $21 million. Anders says it has similar plans for Beijing auctions, and will also hold exhibitions and promote tours.

The opportunity is clear. Asian art sales for Sotheby’s alone have tripled over the past five years to nearly $400 million last year. Its Russian art sales have exploded, from less than $20 million in 2003 to more than $150 million last year. Typically, rich collectors start with their home markets and then expand to the broader categories, such as Impressionist & Modern, and Contemporary, where the really big numbers are.

Auction Remodeling

Both Sotheby’s and Christie’s have ramped up their internet strategies, though in quite different directions.

Christie’s launched Christie’s LIVE last July. Anders says, “This is not a timed auction, like an eBay. It is like all of our auctions: thoroughly researched, catalogued and showcased by our experts.” Since its launch, some 14,500 bids have come through the site, accounting for £4.6 million (€6.8 million) of sales. The top sale to date was “La Terre” by Syed Haider Raza, a contemporary Indian painter, which sold for $408,000 last September during the house’s New York Asia Week sales. The top European sale was “A capriccio of classical ruins with the Arch of Constantine and figures conversing,” from the Studio of Giovanni Paolo Panini (Piacenza, 1691-1765, Rome). It sold for just over €53,000 at the Old Master Pictures Day last December.

Sotheby’s strategy, in contrast, is informed by failed experiences in previous joint ventures with and eBay. “Amazon was not the right partner for us,” says Sheridan. “Their focus was on their core business, which I would describe as a retail model. We tried again with eBay — they liked our high-end brand, our high-end price point, we liked their technology. But we didn’t see the revenue growth we needed to continue in that business. At our price points, where each object is unique, people want to see it, touch it, understand the condition, really look at it with their partner in life and say, ‘Yeah, this’ll look good on our mantle or on that wall.’ We decided that it was prudent to exit that business and it helped us to reduce our overall cost structure.”

The new is designed more to give clients access to their own financial accounts, information about opportunities to buy and sell, and downloadable reproductions and reports on the conditions of objects of interest to them. As Sheridan says, this builds on a nuts-and-bolts CFO initiative he took when he arrived at the house in 1996: the consolidation of the several dozen systems used by the company into one SAP system. “This gives us a real competitive advantage versus Christie’s,” Sheridan reckons. “They just went out and hired a new CIO to rebuild their infrastructure because they feel we have a competitive advantage.”

In the past month, Sotheby’s has taken another major strategic decision driven by costs and an eye on the bottom line: Sheridan announced in March that it will no longer accept commissions for items below a value of $5,000. These accounted for about 47 percent of its auction volume, but only 2.5 percent of net sales, last year. It will result in a 5 percent cut in staff (between 70 and 100 people) and the closure of some sales rooms.

Art History Lesson

As the dust cleared from the antitrust suit and it became clear that the two companies’ brand strength would pull them through, both also stepped up initiatives to extend their brands. In another initiative in February, Christie’s moved into the primary art market for the first time, with the purchase of Haunch of Venison Partners, which sells the work of contemporary artists through its galleries in London, Zurich and Berlin. Anders says Christie’s plans to open a Manhattan Haunch of Venison gallery this year.

For its part, Sotheby’s sold its international property unit to Realogy (formerly Cendant) in 2004, retaining just a 9 percent stake. But it plans brand extensions in other areas. For example, it began auctioning high-end diamonds (price tag $50,000 and above) a year ago. Sheridan also sees financial services as a promising area of growth. Last month, Sotheby’s said it will launch two branded credit cards in a venture with GE Money and MasterCard, giving holders special access to museums and other art events.

Sheridan also has ambitions to aggressively grow Sotheby’s lending business, which had to be scaled down during its troubles. This has more than doubled over the past year, to a loan book of about $200 million. “We’d like to see it go much larger,” says Sheridan. “We’re going to do more marketing and add people and resources,” to exploit an area where would-be competitors have failed. (See “Art Hedge Hype,” at the end of this story.)

With things looking so dire three years ago, why does Sheridan think the duopoly survived and thrived? “Duopolies exist because the market won’t support many players,” he argues. “If there were to be a big price war among eight global auction houses, you’d end up with Detroit and the U.S. auto industry.”

The failure of LVMH’s strategy to grab a meaningful slice of the market certainly resulted in a radical retooling of Phillips. That failure was a combination of bad timing, bad management and hubris of novelistic proportions, the most dramatic of which were guarantees of $300 million for two art estates in 2001, with an auction result less than half that. (Although a record sale price for four Klimts last year reduced LVMH’s ultimate losses to nearly nothing). There were also tales of outlandish spending (such as $100,000 for an auction podium) and dramatic disagreements between the two top executives, the flamboyant Simon de Pury and Daniella Luxembourg, both former Sotheby’s experts.

In the wake of all this, de Pury enlisted Brook Hazelton, a Goldman Sachs banker he had met in Geneva in 2004, to work out a different business model for Phillips. Hazelton, now managing director of Phillips de Pury, ruled out another head-on assault on Sotheby’s and Christie’s. “If you think about the dominant market position that those companies have, it is surprising how limited their profitability is,” he says. Apart from the extraordinary past two years, this is barely above 10 percent a year on average over the previous decade. He also ruled out a purely regional strategy.

Instead, Phillips is pursuing a “niche boutique” strategy focusing on four lines — ultra-contemporary and modern art (from 1980), photography, design and jewelry, where it aims to be category leader. It is modeled, Hazelton says, along the lines of players such as Antiquorum, the leading antique watch auctioneer.

The company is slimmed down, with sales last year between $150 million and $200 million. And it has moved from the legendarily expensive midtown premises in Manhattan to more modest, but “hipper”, showroom digs downtown. Hazelton has also put in some unhip, but essential processes, such as budgets and inventory management. The company was also turned into a partnership, with 11 of the key experts and management holding stakes.

Fine art is a unique business and expert talent is at its core, Sotheby’s Sheridan says. “But — and I don’t want to blow my own horn here — I do think you also need some management talent and financial discipline.”

Art Hedge Hype

“I’m not a big fan of the art funds,” says William Sheridan, Sotheby’s CFO. Though there’s been talk for years of the emergence of hedge fund-type investment vehicles being set up to add a new dimension to the art market, there is little evidence that any have gained traction. Similarly, banks have made little headway in art-related lending. ABN AMRO, for example, shut down its art advisory group last year, after less than a year of operation.

The news isn’t getting any better. This March, Fernwood Art Investments — a fund set up in 2003 by a former director of Merrill Lynch and closed last summer — was sued by former investors who allege proceeds were simply used by the founder to promote himself and his spouse in the art world.

“There is a lack of transparency. They’re illiquid assets for the most part — you can’t look up XYZ Picasso on Bloomberg every day — and the only market-makers are Sotheby’s and Christie’s,” Sheridan says.

Brook Hazelton, a former investment banker who’s now running Phillips de Pury, adds, “Art funds are a dangerous concept. What is the exit mechanism? In a fund context, for example, different investors would have different timeframes presumably — how do you manage that conflict?”

Art as an investment class is a sound thing, Sheridan concludes. “But if you’re really interested in that you should buy Sotheby’s stock, because we reflect the general art market better than any other art barometer.” —T.M.