StepStone Group Inc. (STEP) Earnings Call Transcript & Summary

Great. Good morning, everyone. For important disclosures, please see the Morgan Stanley Research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. Great. With that out of the way, good morning, everyone. Welcome back to day 2 of Morgan Stanley's Financials Conference. I'm Mike Cyprys, Equity Analyst covering brokers, asset managers and exchanges from Morgan Stanley Research. And for our first session, this morning, we're thrilled to have with us StepStone Group. And with us today is Scott Hart, the CEO of StepStone; and Michael McCabe, Head of Strategy. StepStone, as many of you know, is a global private markets firm providing customized investment and adviser solutions. StepStone oversees about $570 billion of private market allocations, including around $135 billion of assets under management. Scott, Mike, thanks for joining us.

Thank you.

Thanks for having us.

Good to have you guys here. So why don't we start off with the fundraising environment, getting a lot of attention in the marketplace. We've heard from many alternative managers that the fundraising environment could get a little bit more challenging from here, just given a crowded marketplace and also LPs facing denominator effect. So I guess, how would you characterize the current environment and your outlook for fundraising? And if you could maybe split out between the near-term versus the medium to longer term?

Sure. Look, it certainly seems to be the hot topic in private markets right now. And I think -- look, I mean, we at StepStone Group have a unique point of view in the sense that we are not only out there fundraising for our commingled funds and separate accounts, but also spent a lot of our time with our clients on their primary fund allocations. So interestingly have a seat really on both sides of the fundraising table. If I start with what we've seen in our own business, I'd say momentum has continued to be strong. And we talked in our most recent earnings call about the fact that our fiscal year '22, so the year ended March 31, 2022, was the strongest year we've had to date from a fundraising standpoint. We also talked about the fact that, that momentum has continued into the current quarter with about $2.5 billion of commingled fund closings in the current quarter, which has already made it our strongest fundraising quarter to date. But look, certainly recognize that some of that is now backwards looking and what we're focused on is what lies ahead. And I think for the couple of reasons that you mentioned, we expect that the next 12 to 24 months will be more challenging than the last 12 to 24 months, really for the couple of reasons you mentioned. It's a crowded fundraising market. It seems like every GP you talk to is currently in the market raising today. The fundraising time lines have shrunk, now about 2.8 years from fund-to-fund before someone returns to the market. And frankly, we look at our own investment committee activity, over 50% of the funds that we've brought to market this year or that we've looked at this year have been back to market in less than 2 years. And so what that is resulting in is some LP fatigue and frankly, LP budgets that could be spent entirely on re-up opportunities. And as you say, that's all happening at a time where the public markets have declined. And as a result, you're having more conversations about the denominator effect. I don't think it's all doom and gloom. I think as Mike and I traveled the world, one of the things that we find is that for every conversation about the denominator effect we're also having conversations about new pools of capital that are coming online or new allocations that are being made. And so, look, while we are certainly realistic about the environment we are heading into, I think we continue to be optimistic, partially because of how we're positioned, both in terms of the geographic mix of our business, the asset class mix, and frankly, some of the strategies that we manage that we think will be in high demand.

And I think that's a good segue to maybe talk about it from a geographic standpoint, right? So just how does that sort of outlook vary by geography? And how do you think about the positioning of StepStone relative to peers from that vantage point out?

Well, like I think at times, it can be hard to generalize, right? And you have to remember that part of the reason StepStone was founded was in recognition of the fact that no 2 LPs -- no 2 LP types are exactly alike. But you've certainly heard others talk about the fact that U.S. market and maybe specifically U.S. public pension funds are probably under the most pressure. I think there's some truth to that. I mean, I think we've certainly seen many of our U.S. public pension fund clients who have continued to be quite active. But if you do think about the fact that they tend to have the most mature portfolios, maybe they've got less flexibility to deviate from their target allocations, I think there is probably some truth to that. Those that have been investing in the asset class the longest and maybe are therefore closer to their target allocations will be most heavily impacted by denominator issues. You contrast that with what we're seeing around the world, and that's really where we're seeing some of the new pools of capital coming online. Some of those can be quite sizable. And I think heading into this year, one of the questions on our mind was, well -- well, what we're seeing in the public market start to scare off some of those investors? Will they be spooked by what's going on in the public markets? And I think we found the exact opposite to date, right? Which is that, certain of those investors, despite being relatively new to the private markets, are telling us that, look, they've been thinking about allocating the private markets for the last couple of years. The main thing holding them back was evaluation environment. And not that they think they can time the markets perfectly, but certainly feel better about the entry point today. I think to your question around how do we differentiate, part of it is our global and local approach. We have, over the last 15 years, built out a global network of 23 offices with local professionals on the ground, working closely with our clients in those markets. We've got a complete private market solution that we're able to offer to those investors. And look, I think the good news is those investments that we've made in building out that global footprint have paid off over time. Today, about 70% of our management and advisory fees come from clients who are based outside of the U.S. And in the last 12 months, if you look at where our fundraising activity has taken place, about 80% of our AUM additions have come from outside of the U.S. So again, I certainly think those -- the time and effort we've put into the international opportunity have really paid off.

Maybe we could shift and talk a little bit about fundraising from an asset class vantage point. So I guess, how does that sort of outlook evolve if you kind of look at it relative to the different asset classes that you guys are in?

Yes. So look, I think, certainly, some of the comments I've made are probably a little bit more private equity and venture capital specific. And as a reminder, we are active across private equity, real estate, infrastructure and private debt. The business is pretty balanced across those asset classes. And I think in a lot of ways, it's similar to the geographic story that we just told, which is that we have capabilities and exposure that are probably leveraged to some of the faster-growing parts of the market. If you were to look back at the first 7 or so quarters that we've had out of the gate as a public company, each quarter it seems to be a different asset class that's really driving the activity or maybe the outperformance. Specifically asset classes like infrastructure and private debt have been highlighted in recent quarters as strong performers. And so as we think about your question around the fundraising environment across the asset classes, look, I think as we enter this sort of new market environment that we just described, feel good about our ability to engage with clients across asset classes. You certainly -- if you speak with our private debt or infrastructure teams, more conversations today with LPs about how can I get inflation protection perhaps through strategies like infrastructure? How can I increase my ownership of floating rate debt securities? Well, that's exactly what we spent time on in the private data asset class. And so feel good about our diversity across asset classes in this environment.

Now while the denominator effect gets a lot of attention, there is a positive on the other side that I oftentimes think gets missed in the headlines, and that's around secondaries, which could be a real natural and elegant solution there for some of the denominator effect that some people may be facing. So how do you see that playing out? How meaningful of an opportunity could that be for StepStone?

Well, we think it could be a meaningful opportunity. It's one of the things that we highlighted in our most recent earnings call. I think it's interesting to hear you describe it as an elegant solution because I think if you were wind the clock 10, 15 years ago, that's probably not how it would have been described. Maybe there's bit more of a stigma attached to having to tap the secondary markets. But as we think about the opportunity today, I think it's really become a legitimate portfolio construction tool for LPs, who, whether looking to the secondary market for opportunistic reasons, or today, as we start to see liquidity and realization slow down or if they do find themselves over allocated to the asset class. I think we are going to see more LPs turn to the secondary market. We've seen a number of large portfolio sales hitting the market in the first half of this year. Look, I don't think anyone is panicking quite yet. And I do think it will take time before that opportunity really emerges, because there's going to be a real focus on where do March 31, where do June 30 valuations shake out. Making sure that if you think -- you may think you're buying it at a discount today, but if it turns out, you're actually buying it at a premium to June 30 valuations. That's not where you want to be as a secondary buyer. So I think it's going to take some time for that opportunity to play out. But whereas so much of the conversation over the last couple of years, and so much of the growth in the secondaries market has been driven by GP-led secondaries, I think we're going to see some renewed interest in the LP side of the secondary market.

Do you think the market shifts from the GP in recent years back to LP when you think about the mix, how do you see that evolving in the market?

I think -- so I think if you look at the last 2 years, really, almost all of the growth has come from the GP-led part of the market. They're pretty balanced right now. So I would say I'm not -- I don't see the GP-led opportunity going away. But I do think that we've seen uptick in the LP side of the equation.

Got it. Okay. Why don't we talk a little bit about deployment, just how that environment is shaping up, just given the pullback that we've seen in public market valuations. On one hand, opportunities could become more compelling, right? Just perhaps bid offers though, why didn't -- so how do you think about the push/pull there? Do deals get harder to get done? And how do you navigate that across your different asset classes?

Yes. I think it's similar to what I just talked about in secondaries, right? I think there's going to be a couple of quarter lag before we really see activity pick up in a meaningful way. I think, we clearly feel very good about our positioning today, whether specifically on the secondary side, where we've just closed a $2.6 billion venture capital secondaries fund or where we've just had a first closing on our private equity secondaries fund of over $1 billion. And as we've often talked about, currently sit with about $17 billion of un-deployed fee-earning capital, so essentially accounts that pay fees on invested capital and will convert into fee earning AUM as it's deployed over time. Now the time horizon for that deployment is 3 to 5 years. And really, I don't see that changing in any meaningful way. So I think really what we're talking about is how do things evolve over the next few quarters. What we've seen is that the decline in valuations that has taken place in the public markets has not yet translated to the private markets. You still have -- what you have at the moment is buyers who are looking for bargains or discounts based on what they've seen take place in the public market, but sellers who are holding out for yesterday's pricing. And I think it's going to take some time and prices remaining depressed before we start to see those expectations really come in line. I think in the interim period, you may see some more public market type activity or pipe activity. You may see some transactions that have a bit more structure or downside protection to them where if forced to pay yesterday's valuations where you at least want to have some downside protection baked in into that equation. And so I think it's going to take some time over the coming quarters before opportunities really start to pick up. But I think, again, from our standpoint, we've got a long-term horizon. We've done a nice job of maintaining our discipline from a pacing standpoint. And so when I think about the 3 to 5-year time horizon for that $17 billion of undeployed fee-earning capital, really see no change to that equation.

So the time to deploy the shadow capital, if you will, that $17 billion 3 to 4 years, that's unchanged in terms of your expectation there. Okay. So you mentioned the venture capital secondaries fund. Why don't we talk a little bit about the venture capital business for you guys? It's been about 9 months since the closing of the Greenspring acquisition. How is integration progressing? And just given the broader macroenvironment which has changed a bit since you had announced the transaction, I guess how is that influencing the market's perspective on VC as an asset class in your outlook?

Yes. Mike, do you want to jump in on that one?

Yes, sure. Thanks, Mike. So look, we're thrilled with the way the Greenspring acquisition has taken place and the way it's integrated. It became clear to us in the very early discussions that there was a cultural fit between the companies. And we spoke a very similar language and at a very similar drive and a similar vision. That has all played out according to, if not, a little bit ahead of plan. And so when we look back over the last 9 months, I don't think we could have expected as much progress and as much success as we have enjoyed given the backdrop in the markets, we'll talk about that in a minute. What we've been able to do is take a look at their LP base and our LP base. And what was amazing with $22 billion of AUM from Greenspring's business, there was very little overlap between their LPs and our LPs. And so what we've been able to do is find synergies at the top line, where we've been able to cross-sell into Greenspring's LPs and vice versa. Remarkably, the $2.6 billion secondaries fund probably couldn't have been timed better, given where we are in the market backdrop. And we think the re-rating of a lot of the valuations creates a really unique opportunity for our platform to deploy capital into the secondary space, specifically in venture capital and technology. Note that, that $2.6 billion fund raise was a threefold increase over the predecessor fund, which was $800 million. So we're seeing an awful lot of uptick in demand for what we're doing in VC and the innovation economy. And I would say even StepStone's clients on the customized account side, and managed accounts are a big part of our business, are anxious and eager to create managed accounts in the venture capital and technology space. And we've had a couple of early wins and successes there. So all good and very exciting. And I think it sets a tone for how we do M&A generally as a firm. It kind of starts with culture and it starts with how the fit between the teams would work. And that is how we capture our synergies.

So still remain convicted on the Greenspring, acquisition and the opportunity set?

Yes, super excited.

Great. Why don't we talk a little bit about your portfolio and how the portfolio marks are holding up? We're sitting here in June. Your recent March quarter result showed 12/31 mark, just because the way you guys report on the lag with your portfolio. So just curious if there's any sort of color you could share that's more real time and what this could mean for the $1.5 billion carrier receivable balance that you guys have?

Yes. Yes. Look, I think in the same way that our business in general is diversified across asset classes, geographies, industries even -- I would say the same is true for our portfolio. And I think the one thing I would add to that is, I think we have maintained our discipline around pacing as well. And I think that's something that we're quite proud of today. I think particularly when you look back over the last few years and see that many investors, they were rewarded for investing quickly, returning to market, raising a larger fund. I think we did a nice job of maintaining our vintage year diversification which in this environment ought to serve us well. So again, that's sort of our starting point. It's a very well diversified portfolio. I think if we do step back and think about some of the common themes across that portfolio, what we are seeing right now is, look, on average, continued strong revenue growth, but with some margin pressure across some of the portfolio companies, whether driven by wage inflation, commodity prices, supply chain-related issues. So I think similar themes to what you're seeing and hearing from others. But I think the combination of that revenue growth and some margin pressure has still resulted in solid earnings and cash flow growth. The major adjustment we've had is to valuation multiples, right? And so that's why we are very focused on both the March 31 and the June 30 valuations as they begin to come out. I think what we tend to see if you look back at history is that private market valuations tend to follow the public markets, although with a bit of a lag. And oftentimes, particularly in environments where you see the markets go up or down by more than 10%, rarely do you see the private markets move quite as dramatically. But as we look at all the different tools that we have at our disposal as we track the various different valuations as they come in. But we think there will be some pressure on that $1.5 billion of accrued carry over the coming quarters here. But that's after a really several quarter period of very strong performance over the last year, 1.5 years.

And with that context on the performance of the, I guess, portfolio, how do you see that sort of translating and shaping up into the near-term realization outlook?

Yes. So I think from a realization standpoint, look, you've heard us talk pretty consistently during calendar 2021 about the fact that such strong activity and performance was driven by the fact that really all exit routes were open; IPOs, sales to financial buyers, sale of strategic buyers, SPACs, we did GP-led secondaries, right? That's clearly no longer the case today. And so I think we will see things slowed down from the record level of realizations that we saw last year, and I think we'll see a bit of a shift in where the realizations come from. So whereas we've historically had quite a bit of balance across those different exit routes that I just described, I think what we are likely to see going forward, particularly in the near term, is more of the activity driven by financial buyers and again, GP-led secondaries where there's a tremendous amount of dry powder that exists in the market today. And I think that's one of the good things about having a diversified portfolio across small, mid and large cap companies that you have exit optionality. You're not tied just to the IPO market. And even in areas like venture capital, I think there will be an active exit market amongst some of the very large technology funds that have been raised in the private equity space over time here as well as opposed to just being an IPO or a public market story. I think the only -- the last point I would make to just kind of tie together a few of the topics we've just touched on is more of a reminder that when we did make the Greenspring acquisition, which, as you mentioned, closed 9 months ago, what we did not acquire was the historic carry, right? What we really acquired was a stream of management fees and participation in the go-forward carry. So as you think about the movement in the unrealized portfolio or as you think about the realization activity, the movements that we've seen in the venture space won't have a direct impact on that accrued carry that you mentioned.

That's an important distinction there. When you think about the exit environment, maybe just following up there a little bit. Any difference on the real estate, infrastructure, private credit side versus your expectations on the private equity and venture side?

Yes. So I mean, look, I think some of the non-private equity asset classes are very long term in nature. Maybe the returned drivers are less about an exit in a 3 to 5-year time period, but more about the interim cash flows or in some cases, maybe looking to a 7 to 10-year holding period. And so when we think about the evolution of those businesses, they're probably a few years further removed from some of the realizations that we're now seeing on the private equity side. Look, I think there are some similar trends in terms of the growing amount of dry powder and the emergence of larger and larger funds across each of those asset classes that may prove to be another valuable exit route in addition to, again, the public markets or strategic buyers.

And most of the receivables in private equity anyway, right?

Today, that's right.

Yes. Okay. Maybe shifting gears over to retail, that's a topic of great interest to many in the space. You launched your evergreen fund vehicle called CPRIM. I think it's been maybe about a year or 1.5 years or so. It's now one of the wire houses. So I just would love to get an update on how that's progressing, how your retail distribution build out is evolving? And what are the capabilities that your distribution partners are looking for? And how does that influenced your approach?

Yes. So look, I think the build out and the distribution is progressing well. And I think if we think about our internal capabilities, we've now grown the team to north of 30 professionals, increasingly that is not only in the U.S., but have just hired an individual to help lead our effort in Europe. You've often heard Jason Ment, our President, talked about the fact there are really 4 pillars to the distribution strategy across the RIAs, IBDs, the international market and now wire. So we're pleased to say that we've now made progress and are allocating across all 4 of those channels with over 100 distribution partners actively allocating today. The second part of your question around what capabilities, are those distribution partners looking for? I mean that's exactly what we set out to determine a couple of years ago. And so I think we took a similar approach to that, that we take in the institutional market, which was to listen first and really take a more solutions-oriented approach to the market. And clearly, what we heard from the 4 different channels that I just talked about was, wanted a product that was available down to the accredited investor level, didn't want to have to deal with K-1 reporting, didn't want to have to deal with capital calls. Wanted in some cases, they have the ability to have a single ticket solution that got them diversified exposure across the market. You wanted to see the same institutional approach that we were taking with our clients applied to the retail market. And clearly, I think track record matters as well. And I think in the 1.5 years or so since we've gotten started, the tracker on the CPRIM product in particular, has been quite strong. So I think those are a few of the capabilities that I think our partners have found compelling.

And flows in this environment, how is that holding up just given the volatility that we're seeing in public markets? What are you seeing on that front?

Yes. I think flows are holding up to date. I mean part of that for us is driven by the fact that the number of distribution partners has continued to grow. But we have seen over the last several quarters, flows that have been -- sorry, last several months, flows that have been in the sort of $45 million range and that's up meaningfully compared to where we were this time last year. And so I think so far, things are holding up quite well.

Great. So 30 distribution -- or sorry, yes, 30 distribution folks, people, internally salespeople and such, so 100 distribution partners that you have it would seem like this organization and distribution reach that you've built out is perhaps can do a lot more over time. So I guess, how do you think about what's next on the product roadmap? And what sort of lessons would you incorporate as you think about distribution and product development as you kind of roll forward from here, given your experience so far?

Sure. As you've heard Jason mentioned in the past, CPRIM was our debut product, which is really designed to be a single ticket solution for individual investors to get access to the private markets in a diversified way across secondary investments, co-investments and some fund investments and primarily in venture capital, private equity and some other asset classes as well. So it was a very elegant way for the individual investor through a single ticket to get access to a very broad and diversified way in the private markets. Going forward, you can expect to see a pipeline building of products that we will roll out in addition to CPRIM. The acquisition of Greenspring creates a very natural way for us to build something in the venture capital and technology space. And as you asked earlier, one of the things about Greenspring that is interesting is that a lot of our clients were looking for an entry point into this part of the market. And the way the markets have evolved in the last 6 months could very well create that opportunity. I think there's also quite a bit of demand for yield in this environment as well and so maybe something in the private credit space. But we have -- we have a diversified platform across the 4 asset classes and 3 strategies. You can expect to see products evolving around CPRIM to become more diversified and were tilted or more specialized based on what individual investors are looking for. The lesson that we've learned is something that Scott points too all the time, which is it is really critical in our business to listen first and not just go to market with something we think will work, but go to market with something that the market needs and the market is asking for. So our distribution partners and our 30-person team in CPRIM that are selling CPRIM are out there asking the question, what are you looking for? What are the needs and then coming back to the team and trying to figure out what that solution would be?

Great. I'm going to open it up to the audience in just a minute to get your questions ready. I do want to ask about the margin, can't get away without a margin question, right? So you have your near-term margin guidance 30%, expanding to mid-30s over time. So I guess a few things there, like what's over time, how -- what's the time frame for that sort of mid-30s and sort of what's embedded in your assumptions around the near-term 30% guidance?

Sure. Well, let's start with what's embedded in the assumptions. And I think, again, referring back to some of the answers that Scott offered you about geographic footprint, whether it's distribution, we're investing in the business for growth. We enjoyed a 25% growth rate top line over the last several years while we've been able to maintain very healthy margins. If we roll the clock back a little bit to when we took the company public, our margins net of retroactive fees was squarely in the mid-20s, call it, 26% first quarter out of going public. Roll forward to where we are inside of 2 years, we've been able to expand our margins by almost 400 basis points, net of retroactive fees while growing at 25% year-over-year. It's an incredibly powerful combination. A quarter ago, we guided the market to a 30% FRE margin. We hit that margin. And so I guess the message I'm offering is that pretty much what we said we were going to do, we've been able to do. Now when we think about sort of medium to long-term margins in the mid-30s, our priority is going to continue to invest in this platform for growth, whether it's through geography, whether it's through distribution, whether it's through data, technology, investing in our teams. Our eye is on that price, but the operating leverage, as we continue to scale, we expect will continue to grow. And we expect to see that flow through FRE margins as well. So it should still be part of the thesis. We just -- we're just focused on investing in the business for growth.

Great. Any questions in the room? There's a question up here on the front.

I'll maybe ask 2, if I can be cheeky. So first one, in terms of kind of fund distribution platforms like Moonfare and iCapital, how important a role do you think they're going to play in distribution? Or is it going to be more around them helping the, say, wealth management clients process demand and build back office stuff? That's point one. And then second one, just on sort of fund IRRs and LP expectations given exit multiples lower than entry multiples potentially, given inflation and rates and impacts on debt, how are you thinking about likely IRRs going forward versus, say, the 20% top quartile history? And are LPs kind of anticipating that generally or are they unrealistic in terms of what they're looking for -- looking out over the next 5-plus years?

Yes. Maybe I'll start with the second question and we can tag in -- for the first question as well. Look, I think on return expectations. Look, I do think that what has happened over the last several years is that returns have probably exceeded expectations for a number of different reasons, part of which was a continued rise in valuation multiples. I think we have done a nice job of maintaining our discipline, typically assuming when we're underwriting new transactions that multiples will decline. But that also -- that obviously means that you need some time to grow into the multiple that you have paid. And so look, I think as we've seen the markets correct here, we think that it will create an interesting buying opportunity on a go-forward basis. But as there's more dry powder chasing opportunities in the market, I think it is likely that we see returns come down relative to what we have seen over the last several years. Again, the key to us when we think about underwriting new transactions is really having a number of different ways to win. I think what started to concern us in recent years was when you saw deals that were really priced to perfection and really needed everything to go right in order to generate your base case return. We've oftentimes look for deals where regardless of what the base case expectation is. If you thought about the distribution of outcomes, there were multiple ways to win. And if something in your base case didn't go exactly according to plan, there are ways to offset that.

And sure, on the distribution side and retail, the iCapitals of the world are very innovative and they are very much an enabler of how the individual investor can get connected with the asset classes within the private markets. I think it's early in the development of how the industry is organizing itself around the distribution of private market solutions into the retail space. I think StepStone's vision is pretty clear. We've built a vertically integrated platform. So we have the capacity and the capability to pretty much manufacture any solution a client may need. And we have the distribution team out there selling and listening and reporting back to and collaborating with the investment team. So we think that vertically integrated platform is the long-term winner in the space. But there's no question, technology solutions like iCapital are very effective enablers and potential partners, frankly.

I'm afraid we're over on time.

Great.

Went quickly. Scott, Mike, thank you so much. Really appreciated.

Thank you, Mike.