Amy Falls, vice president and chief investment officer at Northwestern University, approaches private credit cautiously, watching its success as an asset class, how well investors underwrite credit risk and how they will cope with a future bankruptcy cycle.
Falls, who has overseen the Evanston, Ill.-based university’s $14.9 billion endowment since 2021, began her career in fixed income at Morgan Stanley in 1994, where she was a managing director and a member of the bank’s fixed-income management committee.
In a June 20 interview, Falls said she primarily sees her portfolio as a set of risk factors.
“I was a bond person. I spent the first half of my career in fixed-income trading and most of it in the high-yield and emerging markets area,” Falls said. “So I look at credit risk as: Where are you on the balance sheet, and your probability of getting repaid and the interest rate you’re getting and the spread you’re getting over Treasuries?”
“So credit is a factor, like equities is a factor. Credit risk is a thing,” she said, “and it’s tied to if you don’t get the upside growth, you should get downside protection. You should be higher in the capital structure, and whether you are or not depends a lot on the covenants and the capacity of the lenders.”
Simply, a lender can take on very little risk and own very liquid bonds or take on the risk of something like high-yield bonds, and “I may think I have liquidity but I don’t really,” said Falls.
Falls said she finds the growth of private credit fascinating because those managers will lend money to a company — and they are going to have a long-term time horizon.
“So the good news, unlike a bank, a bank lends money and is funded by deposits,” she said. “You’ve got very short-term funding, making very long-term commitments. That was probably always a mismatch,” Falls said. “Private credit is in a way a better mousetrap. But it’s also very unregulated. So I think we are still finding our way as to how well are these guys underwriting risk, how well are they going to tolerate a bankruptcy cycle, and will there be a bankruptcy cycle? Because if you keep lending to companies, they’re not going to go bankrupt.”
Falls said she's asking the big questions about when that bankruptcy cycle might occur: Will it just take longer to happen? Will it happen in a different way? And how does the growth of private credit lessen the impact of how the Fed actions affect the marketplace?
“When the Fed changes the policy rate or tightens conditions, that’s primarily working through the banking system. If the banking system is a smaller portion of the marginal lending to corporate America, how is that mechanism working?”
Falls has lived through a number of cycles, and her experience is that with the Federal Reserve now having set the federal funds target range to 5.25% to 5.5%, "we normally would have had a bankruptcy cycle by now. It hasn’t happened yet."
She is asking also whether it’s due to the banking system taking less of a role in corporate lending.
“Private credit hasn’t totally disintermediated the banks. It has at the far of the spectrum. I think the companies that are probably higher risk, higher return from a credit standpoint are more where the private guys are,” Falls said. “It’s interesting to me that it’s much more patient. There hasn’t been a reduction in capital in that space. Of course, the cost of capital has gone up, but the willingness to lend has not contracted because there’s a huge flow of funds into private credit.”
“So the Fed is not contracting credit in that space by raising the base rate. They’re actually making the returns higher, which is actually pulling more money into that space, so it’s actually interesting how that all plays out from an economic standpoint.”
As of Aug. 31, there was no dedicated private credit asset class in the endowment. As of that date, the actual allocation was 29.2% public equities, 20.5% venture capital, 15.5% absolute return, 14.9% real assets, 11.9% private equity, 5.8% fixed income, 1.7% cash and cash equivalents and 0.5% other investments, according to the university’s most recent financial report. Falls could not be immediately reached for information on total investments that she could define as private credit.
Falls said she is being cautious about going into private credit. While it presents a better match between long-term funding and a long-term lending rate, she does worry about the amount of capital that’s entered that market.
“I have some concerns about how much protection is being built into these loans and how the returns would withstand a bankruptcy cycle if and when one occurs,” she said.
Falls said she and her staff are most interested in areas where distress is lining up, specifically in real estate, which she said is having something akin to a bankruptcy cycle.
