In 2012, President Obama passed the ‘Jumpstart Our Business Startups Act’ AKA the JOBS Act. Restrictions on who could invest in certain parts of private markets were loosened to allow non-accredited investors.
One such provision in the law, regulation A, allowed assets priced under $20 million to be marketed as ‘crowdfunded’ investment products to non-accredited investors.
While there had been crowdfunding companies operating for some time, kickstarter was founded in 2009, this was the first time that investments could be marketed and sold in this way. Kickstarter wasn’t selling equity in the products they were marketing. Users financed the creation of a product and received the product itself in exchange for their early backing.
This newly legal crowdfunding investment product opened the floodgates for a new kind of asset. A company could secure a high-priced, hard to access investment and then divvy it up into thousands of pieces for small-time investors.
This allowed several companies to begin ‘democratizing’ access to markets previously unavailable to non-HNW individuals. For real estate, FundRise. For venture investing, SeedInvest (now StartEngine) and WeFunder. For vacation rentals, Arrived Homes. Just to name a few.
Fine art, sports cars, gems, trading cards, sports memorabilia, racehorses, NFTs, video games, books, sneakers, coins, you name it. These things have been called a litany of names in recent years: passion assets, collectible assets, cultural assets, alternative assets, etc.. Some of which have had some track record of investment activity, some less so.
All that needed to be done is form an LLC subsidiary and place the ownership of the painting or baseball card within it. Then, offer crowdfunded shares in the LLC to your users. As long as the value of the LLC does not exceed $20 million it will be in compliance with Regulation A.
While there are several startups that attempted to capture this new market, we will focus on just two of them: Masterworks and Rally. Their stories offer insight into the thesis of collectible fractionalization.
Masterworks’ mission is to democratize fine art investing through the fractionalization of multi-million dollar paintings. Rally, began fractionalized ownership in classic cars before broadening to all collectible categories. Their offerings are priced as low as a few thousand dollars and up to a few million. This price point delta is key to understanding durability of these businesses. But first, a quick primer on the fine art/collectibles market.
One core art world maxim is that the best returns are derived from ultra-rare, ultra-valuable works of art—a convenient opinion to hold if you are an auction house or a gallery. Following this wisdom, art advisors will recommend spending your collecting budget on one highly regarded work instead of ten lesser ones. The same way a financial advisor might suggest opening a position in Google instead of ten stakes in smaller, less proven firms.
For example, you could acquire hundreds of Picasso sketches or prints for the price of one of the artist’s significant paintings. The former could seem like a more rational, diversified investment decision, but it can almost be guaranteed that these sketches will not appreciate in value. If anything they would be more likely to fall in value relative to inflation. The canvas, however, has a shot at netting a solid return since its return to the auction block (or private market) will see collectors competing for the chance to own a unique piece that only comes to market once a decade.
This is why Masterworks, well, works. Investors with a multi-million net worth see the value in owning, even if nominally, a beautiful canvas that they could not afford themselves. It is at once a luxury purchase and a relatively sound investment decision.
Rally, on the other hand, started far lower on the price ladder. The initial classic cars they listed on their platform were priced in the six figures, already significantly cheaper than Masterworks’ initial offerings. The third listing on their platform, a Banksy canvas, was filled at $1,039,000 and was sold just one year later for $1,500,000; a 44% annualized return which falls to a still impressive 32% after Masterworks’ 2 and 20 fee structure.
Since, Masterworks has exited a handful of other paintings on their platform. Always for a positive return, though, not always as high as 32%. Reason being they have complete control over the circumstances by which a painting is bought out. Rally allows each asset’s holders to vote on the acceptance or denial of an exit price. More ‘democratic’? Yes. Better for returns? Maybe, but probably not?
This isn’t to say Rally has not achieved good returns for their investors, in spite of the hundreds of assets on their platform currently underwater. They achieved a stellar result in the sale of an original sealed copy of Super Mario Bros. on the NES. It was offered for $150,000 in August of ’21, then one year later it was sold for $2,000,000 in the height of the speculative bubble that followed Covid; a 1233% annualized return. And since Rally takes a 7% fee from sourcing each deal instead of MW’s 2 and 20, this massive return went straight into the pockets of their users.
Sadly, depending upon a one-off speculative bubble does not a dependable business model make.
But it does help illustrate the core difference in incentive alignment between these two players and their respective users. To reach scale, Rally would need to continually source more and more deals for their platform, but the performance of those assets following the listing does not directly affect Rally’s revenue. Rally saw themselves as just the marketplace as opposed to an investment manager. Leaving users to consider the investment-worthiness of each listing for themselves. So, in the mania that was 2020-2022, they began to source more deals.
In this time they listed hundreds of assets of varying value. A sealed GameBoy Color for $6,500. A sealed NES copy of 1991’s Simpsons: Bart vs. The Space Mutants for $18,500. A Bart Simpson signed sketch for $21,000. Lots of Simpsons fans on the platform, it seems.
Rally’s sourcing pipeline was on fire in this era with new listings getting filled in mere minutes every week. They had to keep raking in those sourcing fees, right? It is hard to blame them since almost any other startup in their position would have made hay while the sun was shining.
As interest rates rose and other macro factors sent broader markets into a tailspin, assets on their platform followed suit. Users took notice of the steep drop-off that would regularly occur following the opening of the trading window for new issues. Soon enough, new listings would go unfilled while fewer and fewer listings were being put up on the site.
This phenomenon shows us two core issues with how Rally intended to fractionalize the market for collectibles. One, the platform’s misaligned incentives with its users. Their revenue growth relied on sourcing new assets, but in doing so they offered hundreds of low-quality assets with poor potential for returns. When this poor performance came to pass users would not participate in new offerings.
Two, the regulatory/operational burden that comes along with holding hundreds of these assets becomes too unwieldy to bear. Holding these assets can be very costly, even when considering Rally factored these costs into each list price. Insurance, storage, transportation, and legal fees on top of their own costs in building and operating a stock exchange (as well as a museum). Not to mention that many of their assets were not, until recently, investment grade assets. Meaning they had to pay likely high-priced lawyers to navigate these new, and often confusing, SEC regulations. And since each asset is technically an LLC subsidiary, each one requires regular compliance upkeep. This headache is only exacerbated by this SEC’s hostility toward sellers of novel financial products. Rally themselves recently settled with the SEC on charges of operating an unregulated exchange.
These two issues were navigated by Masterworks much differently than Rally. Although, they were heavily advantaged by art being an investment product since the dawn of the 20th century. And, that they had access to ready-made infrastructure for much of these issues.
‘Freeports’ allow collectors to house their paintings in a climate controlled warehouse, Masterworks now has the volume to strike a deal with one such establishment to store their portfolio. Just in terms of space, storing hundreds of 20 x 36in canvases is far cheaper than any number of Ferraris, meteorites, fossils, or bottles of wine could ever be.
Insuring high-end fine art has been a cottage industry for decades, giving Masterworks far more cost-effective options than could be offered to Rally for their array of diverse collectibles. They had the same lawyerly woes, but their higher AUM and fee structure could more easily overcome such costs.
Rally and Masterworks’ positioning each allowed for different opportunities around growing their offerings. Masterworks began with multi-million dollar paintings, a few of which found double digit annual returns. This earned them a reputation as a responsible steward of capital. So they were later trusted to head downmarket with offerings in the low six-figures. Rally’s swift movement into cheap collectibles showed themselves to be only a marketplace, with the fiscal responsibility distributed out to each user. In time, this kept them from being able to envelope more of the collectibles market into fractionalized offerings. Who would buy shares in an asset worth just a few thousand dollars? Especially if similar ones regularly fell in price dramatically after the opening of their trading window.
Recently Rally has come to terms with a few of these problems. They are still filling new listings, but are focusing on far higher quality collectibles. They just fully filled an offering for a package of ten Lebron James Lakers jerseys for $500,000 and one for Mickey Mantle’s childhood home for $329,000. Both filled near instantly. While these two may not be at the level of a $10 million Monet, they are true cultural assets. And while they may or may not yield an impressive return, these two are good examples of the fractionalization use-case. Most people will not have the cash to buy such properties outright, but would love to be involved fractionally.
There are much, much more examples of collectible fractionalization not living up to the hype. Collectable, Rares, Otis (now Public), Mythic Markets, Liquid Marketplace. All of these startups were attempting to fractionalize slices of the collectibles market. It is a credit to Rally that they have continued operations this far considering the collective fate of their competition.
I chose to pick on Rally here because they were by far the most successful. Evidenced by a $30 million series B raise led by Accel. They had tens of thousands of users on their platform trading shares of tens of millions of dollars worth of collectible assets. Did they luck into some amazing timing with covid and free money? Sure, but they made a massive impact on collectibles markets the effects of which will be felt for years.
Rally recently raised a few million dollars in a down round with hopes of reorienting their platform towards assets and partnerships that better fit their use-case. Hopefully Rally has learned from their mistakes and will transition their product into one that can sustainably serve their user’s interests as well as their own.
So, was the fractionalization of collectibles a zero interest rate phenomenon? Or is it here to stay?
The first phase of fractional collectibles was certainly very ZIRPy. So many of these platforms were not designed with an eye for sustainable business. They captured the anomalous demand for speculative assets post-covid, but these assets took such a hit that their demise was nearly guaranteed.
Even Masterworks has encountered its own fresh set of problems. They have begun placing irrevocable bids and guarantees on lots that go unsold at auction to source fresh works for their platform. Much like a certain former Sotheby’s chairman who built his collection by acquiring works that went unsold. Not necessarily a strategy that brings A+ works to their users. But that is a post for another time.
Trying to Understand 