Sotheby’s and the art of profiting from a fee cut

By Aaron Brown

Auction house Sotheby’s made news this month by announcing a fee cut for buyers of fine art and other luxury goods. This marked a sea change from the steady increases that have taken the buyer’s premium — what the winning bidder pays on top of the bid price — from 10 per cent when Sotheby’s introduced it in 1979 to the current 26 per cent. The fee will fall to 20 per cent under the new arrangement.

Sellers will pay a 10 per cent commission up to a $50,000 cap, with Sotheby’s standardizing formerly bespoke discounts and kickbacks that were widely reported under the existing system.

Economics has been famously called the “dismal science,” with some justification, but it is also often the contrarian science. An accountant would agree that Sotheby’s has cut fees, but an economist would not be so sure. Do art lovers and investors come out ahead in this new structure?

Consider the example of a painting with a “hammer price,” or winning bid, of $400,000. The buyer would pay Sotheby’s a 26 per cent premium, for a total of $504,000. The seller would pay 10 per cent, $40,000, and receive $360,000 from the sale. Sotheby’s would pocket $144,000; 28.6 per cent of what the buyer actually paid. In the new structure, the buyer’s premium is reduced to 20 per cent, or $80,000, so Sotheby’s collects a net fee of $120,000, 25 per cent of the $480,000 the buyer pays.

But there’s a questionable assumption in this comparison — that the hammer price does not change with the new fees. In fact, Sotheby’s said in its press release that one goal for the change was to raise hammer prices.

First consider a pure art lover, who cares nothing about the resale value of her purchase. This might describe some museums that never expect to sell the work, and perhaps obsessive collectors. If that person were willing to spend $504,000 today, under the new buyer’s premium she could raise her bid to $420,000 and still pay $504,000.

In this scenario, Sotheby’s ends up with $126,000 for its trouble. That is less than the $144,000 it would get under the current fee structure, but only 12.5 per cent lower, not the 23 per cent lower of moving from a 26 per cent buyer’s premium to 20 per cent.

But this is only a pure art lover. At the other extreme, consider a pure investor who will put the object in storage in hopes of selling it in the future at a higher price. If this person were prepared to pay $504,000 for a painting for which he expected to receive only 71.4 per cent of the future sale price, under the current commission structure, he should pay more when he can keep 75 per cent of the eventual sales proceeds under the new structure.

Calculating how much more requires knowing the investor’s appreciation expectations, cost of capital, horizon, taxes, storage and insurance costs and other variables. However, it’s easy to construct plausible scenarios in which he is willing to pay 15 per cent more, meaning that Sotheby’s collects a bigger fee under the new structure than the old.

So we can say that investors will increase their bids by more than art lovers, meaning more art is used for investment rather than enjoyment, and Sotheby’s might well collect higher gross fees as a result.

There remains one other source of profit for Sotheby’s. Art buyers are likely to give back some of the what they gain from decreased commissions by putting objects up for auction more often, further augmenting Sotheby’s gross profits.

Of course, I am just playing around with some numbers under simple assumptions. The economics of art markets is complex. I’ve ignored many costs including insurance, transport, storage, and taxes. I’ve treated Sotheby’s as a monopolist when it competes with other major auction houses, online sellers, galleries, and other entities. I’ve no doubt that Sotheby’s financial analysts, armed with reams of detailed data and inside market knowledge have done these kinds of calculations with far more sophistication and accuracy — and determined that the new fee structure will increase their revenues. It may be a fee cut for the press release but my faith in the markets makes me confident it will direct more money from art buyers and sellers into Sotheby’s coffers.