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

Okay. Good afternoon, everyone, and thanks for joining the conference. This is Samantha Platt from Bank of America. And it's my pleasure to introduce Mike McCabe. Mike is a Partner and a Head of Strategy at Stepstone. He's also a member of the Board of Directors. Mike joined StepStone in 2010 and has been in the industry since 2005. StepStone is a global private markets investment firm with over $600 billion of AUA and $134 billion of AUM, focused on providing customized investment and advisory solutions to clients. Mike, thank you for joining us today.

Thank you very much, Sam. It's a pleasure to be here.

Great. So let's start with an overview of the company. StepStone has been growing incredibly quickly over the years. Can you take a few minutes to provide context for what you do as a solutions provider and how these solutions are valuable across different market backdrops?

Sure. Well, thanks, Sam. Why don't I start answering the question maybe by zooming out a little bit and start with what our clients are looking for. And I think it's, for the most part, best described as clients are thinking about their portfolio construction, first, from a strategic asset allocation perspective. And they ask themselves, "Okay, how much of my portfolio can I afford to be illiquid?" Why? Because that's where the excess returns historically have come from. And there's persistence with that alpha embedded and the liquidity discount of being illiquid. So the question investors are asking themselves, how much of this illiquid security can I own? I'm going to max that out. And in the institutional world, what we're seeing is allocations to the private markets have been roughly growing and are now anywhere between 20% to 30% of their portfolios in illiquid markets, the private markets across private equity, venture capital, real estate, infrastructure and credit. StepStone's role is to help those clients achieve and maintain those portfolio targets across the asset classes and across the strategies in a diversified way, and we'll talk about managed accounts later and in a customized way. And we do it in a very geographically diversified way. So let's break that down a little bit more. So if we think about an investor who's thinking, okay, I can reach a 30% allocation to the liquid, how am I going to do that? What percentage should I allocate to PE, VC, to real estate and then credit? We will help them design what the underlying allocations are across the illiquid securities. And we've purpose-built the business here at StepStone to have large dedicated investment teams in venture capital, in private equity, in real estate, in infrastructure and in private credit. Going to the next layer down, well, which strategies should clients pursue within each asset class, fund investments? If it's a fund investment, which manager should I pick? The complexity of thousands of PPMs showing up every day and every year makes it a challenge for the average investor to figure out which funds to pick or a secondary strategy, and we'll talk about secondaries in a bit; or co-investment strategy, and we'll talk about that as well. So you have the asset classes and then you have the strategy. And then the last layer down is geographically speaking, where are investors in their process of reaching their target allocation? The U.S. is a fairly mature market. We're seeing allocations roughly at or close to wherever their targets are, and it might be growing a little bit. Outside of the U.S., what we're seeing is the strategic asset allocation models in Europe, the Middle East, Far East and Latin America are starting to catch up to the Western models. And so they're starting to adopt the 20% to 30% allocation to the illiquid markets, and they're at 1%, 2%, 3% or 5%. Who are they going to get to help access the private markets to get them to their targets? The answer is StepStone. And so we've specifically and purposely built our platform with a footprint that is largely outside of the U.S. And so 70% of our management and advisory fees are coming from outside of the U.S. where they're underallocated. And nearly 75% or 80% of our growth, to your question, has come from the geographies. So that's sort of a comprehensive answer to your question.

And you've touched on being diversified across geography, asset class and strategies. How does this help you during periods of market distress?

Yes, we're purpose built for an all-weather cycle situation. Well, I'll talk for a little bit about in a counter -- in a cycle situation, I'll first begin by saying, all right, well, within which asset class might there be more interest? And so think about that through the lens of strategies. So from a primary strategy standpoint, investors might say, "Huh, interest rates are going up. What asset class or what kind of fund will help me navigate a higher interest rate environment?" Well, infrastructure and real estate are natural hedges against higher interest rates. So the inbound calls we're getting from interest on those two asset classes from a primary standpoint are increasing. The same thing in venture capital. Venture cap -- great companies are built in every cycle, and venture capital has always been and has stood the test of time that way for investors to get access to great companies in good times and in bad times. So from a primary standpoint, we're seeing a lot of demand for infrastructure, real estate, and believe it or not, venture capital. And lastly, what's going on with interest rates, our investors are focusing in on strategies that are floating rate. So how do we take advantage of this increase in interest rates? So from a private credit standpoint, StepStone's private credit platform focuses in on floating rate securities that are the most senior in the capital structure, mitigating the risk of those. Now pivoting to, from a strategy standpoint, secondaries become this really interesting countercyclical way to access the private markets at an attractive entry price. And so they're coming in at a discount. And typically, the discounts widen during periods of dislocation or stress. And so there's a really interesting demand that we're seeing, and we're talking about secondaries more, ticking up within the secondary space. So what we've done is we've created a secondary platform for venture capital. We're currently investing out of a $2.6 billion secondary fund dedicated to the venture capital community. It's the largest ever in the history of the asset class. We're currently in market with our flagship private equity secondaries fund with a secondary fund for private equity. We have launched our real estate secondaries fund, which is looking at recapitalizing GP's assets and liquidating LPs out of their securities. And we do secondary investments for infrastructure through managed accounts, and we do secondary investments through managed accounts through private credit. So we've applied the secondaries capabilities that we have across all the asset classes.

Great. So maybe let's continue on with secondaries for a few minutes. You've been one of the largest players, and it's one of the fastest-growing segments of the market with some of the highest barriers to entry. Can you maybe take a step back, discuss the differences in the GP- versus the LP-led secondaries? And where you're seeing the most demand today?

Sure. So thank you for going to the bigger question, so I'll take a step back and zoom out. The secondary business is a derivative of the primary business. And so the way to think about the secondary TAM is by starting with the primary TAM. Trillions and trillions of dollars post GFC have poured into the private market from a primary fundraising standpoint. Some percentage of that capital will turn over in the secondary market. Let's start there. There's currently $10 trillion of net asset value in the private markets sitting there, waiting for either an exit by the general partner and/or the secondary market to buy and purchase. Of that $10 billion, $7 billion is private equity. The other $3 billion are the other asset classes. If we look at the volume of secondary transactions in 2022, I think the number was something like $108 billion. And then if we go to the next layer down, say, and unpack what comprised of that $108 billion, roughly $50 billion came from GP-led transactions. The other $58 billion came from LPs selling their interest. Why is that significant? Let's dial the clock back to 2016. The transaction volume in 2016 was roughly $37 billion. Let's just call it 1/3 of where it was in 2022. And if we unpack the $37 billion, roughly $25 billion of the $37 billion were LPs selling their interests. And the other $8 billion were GPs looking to either restructure their funds where they're like an asset that they want to continue to hold. So if you look at the growth between the LP component going from 25 to 50, it's roughly a double in that time frame. But if you look at the GP lag going from 8 to 50, it's nearly sixfold. So you're seeing the data showing how the GP-led component of the secondary market is nearly half. [indiscernible] of StepStone is we think that, that ratio is roughly going to be the same going forward. Why? Because GPs have found a way and secondary investors like StepStone have found a way to come together to provide a continuation mechanism in an aligned way to continue to kind of enjoy the gifts that keep on giving in the private market through the GP-led continuation plan. And I think the LP market will continue to be incredibly robust, and there will always be some percentage of the primary market that turns over in the secondary market.

So you've been a pioneer in the space, particularly with one of the first real estate secondaries funds, the largest venture capital secondaries fund. Have you seen any demand on the infrastructure side? Or are there any other places that would be a natural kind of next step for StepStone here?

Sure. No, that's right. It's interesting you led with the real estate team because we have the original secondaries team in real estate that dates back to the late 1990s. And what's interesting is we are talking about, in just a minute ago, how GP-led transactions in the private equity space are this new thing. Well, in the real estate market, GP-led transactions were the secondary market. It was GPs figuring out a way to recapitalize the capital structures within the real estate properties that they owned. It was less about LPs selling an interest in a fund. And our team many, many years ago kind of built the Trojan Horse, built the technology to recapitalize GPs. And so that's where we led and we have a veteran team that is currently in market with that very fund that does that. In venture capital, the acquisition of Greenspring really was such a strategic move for us and such a great boom for our organization in the Greenspring team, which is why we led with a secondary fund as their first offering post acquisition. And it's not necessarily a big surprise, but I think we're all very pleased with raising $2.6 billion at a time when valuations are down 50% or 60%. The $3 trillion differential of the [ $10 billion trillion ] in the ground, which is infrastructure, private credit and real estate, allows us to play in those markets. And I think, as I mentioned, we're likely going to continue to use our managed account structures to invest in infrastructure through secondary deals and through private credit through managed accounts. So we're well equipped to pursue secondary investments across all the asset classes.

Great. So maybe we can move to your capital distribution and dividend approach that you recently announced. So you're going to continue paying your quarterly dividend in addition to a dividend tied to your performance fees. Does this approach change how you think about inorganic M&A opportunities in the future?

Yes. thanks for asking this question. It's really important. We were very excited to announce last year a change in our capital management approach. We went public in September of 2020, and we basically conformed to the industry. And we looked around and we said, "Well, we're just going to do what everyone does." A couple of quarters into being a public company, we were being asked this capital management question, and it started to like dawn on us that, "Wait a second, if we look at how cash is flowing into our business, it's coming from two sources." It's coming from fee-related earnings. These are management advisory fees, net of expenses, have our FRE. That is a very stable, steady, very predictable source of cash flow 5, 7, 10 years out. But we also have this performance fee cash flow, where we have $1.1 billion, call it, $500 million of net performance fees sitting as an accrual on our balance sheet that is nothing more than a backlog of future revenue. It will convert into revenue over some period of time. It's just a little more episodic. And so how do you deal with an episodic cash flow and a stable cash flow and come up with a capital management approach. But we just take a step back and we made some calls. We called sell-side analysts. We called buy-side investors, and we really took the temperature of the market, and we realize we need to match the distribution, the capital distribution approach to our business model and allow our investors to experience what we're experiencing. And so we've decided to do is bifurcate the dividend approach. And we're going to pay out most of our FRE in a quarterly dividend. And then we're going to augment that quarterly dividend with a supplemental dividend each year, in June. Our fiscal year ends 3/31 of March. And in June, we're going to announce and issue a dividend that is going to be recurring, and it's supplemental. It's not a special, it's not a onetime thing. And it's going to be largely a full payout of our performance fees subject to Board approval. So what we've done is we've just simply matched our capital distribution approach to our business model. And so we weren't -- no more "square peg, round hole" kind of thing. This makes industrial lodging, does not impede our M&A capabilities whatsoever. We have a very capital efficient business. And we have a very capital -- we have a very flexible capital structure. We have a revolver. We use this revolver to flex up and down. And we have an incredibly valuable source of equity. And so if you look back at the Greenspring transaction, it was largely financed out of issuing StepStone equity. And we combine that StepStone equity with an earnout. And why? That is essential for StepStone to maintain some sort of alignment with whatever acquisition we do going forward. So the combination of cash through our revolver, equity and some sort of earnout are the tools we'll use to pursue M&A. So the capital management decision that we made on dividends really has no effect whatsoever on our ability to continue to grow the business for M&A.

Great. And you've been pretty successful with M&As with 8 main acquisitions since your founding in 2007. Can you discuss any opportunities that you're seeing in the market today or any particular geographies or asset classes you'd like to get into?

Sure. I'd like to -- I mean, that's right. We have had a number of M&A transactions through the years. I think what I'd like to do is maybe contextualize our M&A strategy through the lens of what the world was like for StepStone as a private company pre-IPO and what the world is like for StepStone as a public company post-IPO, because they're different. We used M&A as a private company to build the platform. We used M&A to acquire Citi. That gave us a large co-investment team. That gave us distribution. That gave us a track record, and it really enhanced our private equity capability. We used M&A to acquire real estate. We use M&A to acquire infrastructure. We use M&A to acquire private credit. And so we've used M&A pre-IPO as a way to build the platform. Okay, now it's built. And we have the geographic footprint that we want. And we have the distribution capabilities we want. Post-IPO, now how do we think about M&A? Well, we think about it through the lens of accelerating something we're currently doing or augmenting something we're currently doing rather than adding or trying to think about something that we want that we don't have and do something different. What we've done is we've delivered a platform to our shareholders that is purpose-built to augment or accelerate something with an M&A strategy if one presents itself. And that's an important distinction. We're not professing nor are we stating our strategy is to roll up the industry, not at all, but we will be opportunistic. And if an M&A opportunity presents itself and there's a good cultural fit and we can get the structure right and the right alignment and it augments something we're currently doing or accelerate something we're currently doing, I think we have a fantastic track record at doing M&A and bringing on large senior teams. And the trickiest part of M&A is not to get the deal done. The trickiest part of M&A is integrating and making sure the integration happens seamlessly and the synergies are captured. So our focus is on integration, not getting deals done.

Great. So let's move to fundraising. Starting with commingled funds, can you give some color on which of your larger funds will be back in market, both this year and next year?

Sure. Well, we had a great quarter, as all of you know, and that quarter was largely driven by the activation of two flagship funds. And it was a clean quarter. There were no retroactive fees creating noise in the numbers. And so we activated our flagship private equity secondaries fund. We're very excited about the timing of activating that fund. We also activated our global venture capital fund, and we're also very excited about the timing of that. Given where valuations are today in D.C., it's an entry point that a lot of investors are looking forward to taking advantage of. So what are we currently in market with? We're in market with our real estate secondaries fund, as I mentioned, very excited about that. We're also in market with our first commingled fund infrastructure. So we have our first infrastructure commingled fund on focusing on co-investments. We also have a growth equity fund that's currently in market, and we also have direct lending funds that are floating rate, senior direct lending funds also in market. So we feel good about what's been activated, and we feel good about what we're currently in marketing. And we're excited to have some more closings this quarter and closings throughout the year across all of our commingled funds. And by the way, commingled funds that are also in market, which we'll talk about, I'm sure in a minute, are our retail products. And so we have SPRIM, which is our retail product for the private markets. And we have SPRING, which is our retail product for venture capital and growth equity. So that's basically a fundraising list, if you will, of activities in the commingled space.

Great. So I wanted to move to retail now and talk a little bit more about SPRIM and SPRING.

Sure.

So you've had some great momentum here, raising, I believe it's 4x what you were raising last year at a moment when retail demand has come to almost a halt here. So as we think about your retail platform growing, what types of products are you seeing client demand for outside of venture capital?