Crypto, Private Equity, and Venture Capital All Belong in Endowment Portfolios

Fells, 58, arrived at Northwestern from Rockefeller University, a biomedical research institution in New York with a $2.5 billion endowment, where she had been CIO since 2011. Her performance was a standout: The Rockefeller endowment gained an average of 8.4% annually over five years, and 9.5% for the 10 years through June 30, 2020, her last full year at the helm, compared with an average of 5.1% and 7.5%, respectively, for all university funds.

Falls, a former partner at Morgan Stanley, is a board member of the Ford Foundation and the Harvard Management Company, which manages the endowment of Harvard University. She runs the Northwestern endowment with a staff of 23 from an office on the edge of the campus of the private school in Evanston, Ill.

In a recent interview, Falls discussed her outlook for the market, why it’s important to include private equity and venture capital in the portfolio, and her mission for the endowment. An edited version of the conversation follows.

Barron’s: The stock market has been whipsawed this year. What will the second half bring?

Amy Falls: This was a predictable correction. Valuations were too high, given where inflation is. I also have felt for a long time that interest rates were too low. The policy levers that were pulled appropriately hard to cope with Covid created a massive rally, but the valuations weren’t sustainable. In some ways it is healthy to have this kind of a correction.

We are seeing a normalization of interest rates; 3% to 4% on the 10-year [Treasury] is where we should be. The real rate should be positive. You should get something for being a saver. It’s destructive for income inequality, because older people and lower-income people should have a non-equity vehicle for accumulating or protecting their savings.

Is the economy in a recession, or heading there?

A recession is a significant risk. You’ve got fiscal tightening in the roll-off of stimulus. You’ve got monetary tightening, and inflation. All three things are happening. Inflation means you can’t really stop the monetary correction.

There aren’t as many degrees of freedom as in the zero-inflation era we had been living in. The good news is there is strong employment. There is wage growth, which is probably OK if it doesn’t get out of control. The risk of a recession is pretty high, especially six months from now.

In the 12 months through June 30, 2021, the Northwestern endowment gained 42.2%, beating the average gain of 30.6%. That performance was helped by the fund’s venture-capital investments, up 115%. The performance was mostly your predecessor’s. What are you doing differently, if anything?

The asset allocation isn’t something I would change radically. [The largest positions at May 31, were 34.6% in private equity and venture, 21.4% in long public equities, 14% in absolute return, and 14% in real assets]. A return of 42% sounds great. But everybody’s got the same tailwind benefit of big venture-capital investments. I felt we should take some chips off the table. So we did a secondary sale of privates [holdings in nonpublic companies] in the fall, and raised cash on the theory that when things go up 115%, it’s a good idea to sell.

We also reduced overall equity exposure on the public side. So we tried to pull boats into the shore a little during the fall, and went into January with about 13% cash and fixed income, which is high. [It’s 10.1% as of May 31.]

And more recently?

We’re looking carefully at things that are more cyclical, which have held up well. We’re re-examining just how far through a correction are we? We dribbled in. May was the predominant month of adding. We started to add in June a little bit in distressed-debt funds, on the idea that the cost of capital is going up, and credit spreads are beginning to widen. It’s early, but by the time we give them the money and they deploy it…

We are rolling into opportunities gradually as we see them becoming priced in. More recently we have turned to distressed credit markets. It’s also a bit early but we’re setting ourselves up.

Was the venture portfolio concentrated in a few sectors, or broad?

It was pretty broad. There was a component in fintech and crypto, but it wasn’t very big. There was a lot of the standard story of accelerating change because of the pandemic. We are tilted toward early-stage venture, which is doing a little better than late-stage. We don’t have a single name in the venture portfolio that has risen to be more than 1%. You can get one of these huge unicorns, and then you have a company that is 4% or 5% of your assets. This was pretty broad-based, with information tech and a little biotech, and it was global, not just the U.S.

Performance for fiscal 2022 will be under your helm. [School endowments report investment returns in the fall after their private-equity portfolios are valued.] How is performance shaping up for Northwestern, and are you worried about the returns on your private-equity holdings?

I expect we’ll see some drag on performance from privates. It’s been offset to some degree by real estate and commodity-type investments. We did an analysis for the board that by the end of May, 70% of public-equity underperformance came from 12% of stocks. A small number got hit really badly. A third of the portfolio is either flat or up double digits, and the equity is down. Let’s make it a simple headline. Diversification worked.

Can endowments meet their typical target return of 7.5%, based on spending needs, inflation, fees, and expenses?

That’s the thing that keeps me up the most at night. The problem is, the 5% draw [for university spending] is pretty consistent across the board. What is not knowable is the inflation or cost growth for universities. Unless you can generate returns that cover that, you are depleting your resources in real terms. You’ve got to be in venture and private equity, and you have to take equity risk.

How many managers are you invested with?

The current active lineup, excluding the tail of private-equity managers we aren’t still investing with but have exposure to, is about 107. I’d like to see that come down. I believe in concentrating with high-conviction managers, and then making sure they have a substantive percentage of the portfolio. I would define that as 2% to 3%. If it’s a super-narrow mandate, less. I try to keep anybody from getting too dominant.

What would be your ideal number of managers?

Maybe 90. Where it gets tricky is how much you want to do in sector funds. At Rockefeller, with a $2 billion endowment, I didn’t do a lot of investing with sector specialists because it can be very hard to rotate in and out of them. So I’d pick a good generalist, and they’d decide it’s a good time to be in biotech or healthcare or whatever. As you get bigger, you can add some value by picking a great biotech manager or a great Brazilian manager. My best estimate right now is, we probably have trouble taking it down below 90.

How much do you consider geopolitical risk?

We have to look at geopolitical risk. It’s hard to handicap. I don’t think we predicted [Russia’s invasion of Ukraine]. We didn’t have a lot of exposure in Russia because it wasn’t an appealing investment climate. If a country’s not being predictably governed, it’s typically not a great place to invest. We had very little discussion about Russia and Ukraine until right before the war. We think a lot about the political economy because you have to. But we limit our investments in places where we feel we’re not likely to get it right.

How are assets allocated geographically?

We’re still pretty U.S.-centric—about 70% U.S., if we look at the holdings of all of our managers. Some of that is because we have funds explicitly in the U.S., and also, we have funds that have some form of a global mandate, but have been overweight the U.S.

Is the endowment investing in the crypto space?

Only in venture-capital firms that invest in blockchain infrastructure. Generally, they also then end up with coins of some form or another. We have investments with a couple of strong players in the overall development space.

Why is it important to be in the crypto space?

The feeling was that some of the most talented, thoughtful people in the venture-capital funds that we invest with, who were generally very good at identifying trends five, six years ago, were putting resources into the area. As someone who’s worked in financial systems and trading systems, I like the idea of better, lower-cost ways of moving money around the world. I get the negatives, but there are some real positives. This is not a technology that you can ignore, which is different from saying, ‘It’s the new gold, or everybody should have 5% of their portfolio in crypto.’ I’m not sure about that. I am certain that this is important technology, and that it is a different way of storing and transferring value.

What brought you to Northwestern?

I wanted the opportunity to teach and to work with young people. [Rockefeller has postdoctoral students and no undergraduates.] It was something I admired so much about David Swensen [the late endowment manager at Yale], who was an important mentor. He didn’t just do his job. He taught, mentored, and developed people. It is a good pathway for getting people from non-obvious backgrounds to consider the field.

What is your mission for the endowment?

The obvious, most important mission, is to steward the assets for the institution, and that means both protecting on the downside, and generating competitive returns. If you don’t protect on the downside, in the long run you won’t be generating competitive returns. Managing the risk is critical. But we also want to generate top-quartile returns. Otherwise, we’re not going to be able to compete for faculty and students.

Thank you, Amy.

Write to Mary Romano at mary.romano@barrons.com