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

All right. Before we get started, for important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. Note that taking of photographs and the use of recording devices is not allowed. If you have any questions, please reach out to your Morgan Stanley sales representative. All right. Welcome. We're into the home stretch here. Thanks for joining us at the Morgan Stanley Financials Conference and staying with us. I'm Mike Cyprys, equity analyst covering the brokers, asset managers and exchanges from Morgan Stanley Research. And with us today, we are thrilled to have with us Scott Hart, the CEO of StepStone; and Mike McCabe, Head of Strategy. StepStone is a global private markets firm providing customized investment and advisor solutions. StepStone oversees $620 billion of private market allocations, including around $138 billion of assets under management. Scott and Mike thanks for joining us.

Thanks for having us.

I appreciate you making it out here. So why don't we start off a bit on the business model. As a solution provider in the private markets, you're a bit different than the GPs that most people are familiar with here. You help provide asset [ managers ] with access to the private market. So maybe you could talk about your value proposition, how that has evolved? What's the profile of the customers that are using your services as opposed to going directly to the GPs themselves?

Okay. I think that's probably a good place to start today. You're right. We are a bit different than the GPs that many of us are so familiar with, and that we really work with our clients, asset owners, to help them deploy and allocate, in our case, over $80 billion into the private markets asset classes on an annual basis. And we do that in a couple of different ways, either by helping them to build customized portfolios that are designed to meet their specific needs through some combination of primary funds, secondary and co-investments or increasingly, in particular in parts of the business like the private wealth space, designing products that are specifically designed to meet the need of an entire class or category of investor. But when you think about particularly our institutional clients, one of the things that we shared at our recent Investor Day, if you look at our average private equity clients, they had a 5-person team covering private equity. And that's at a time when you think about the private equity or the private market landscape more broadly, it has become increasingly global, it has become increasingly complex when you think about the proliferation of the number of strategies, substrategies, underlying managers. When we look at the growth and the number of managers that we have monitored in our database over time, about half the growth has come from outside of the U.S. About half the growth has come outside of traditional buyout and venture strategy. So relatively small teams, resource constrained in the sense that many of them sit in a single office location yet being asked to cover an increasingly complex global private markets landscape. And so in many cases, the conclusion these clients reach or maybe are even forced to make is to partner with a group like StepStone, it becomes more efficient, more cost-effective to leverage our resources, our 300-person plus investment team around the world, the incredible amount of data and information that we have at our fingertips. And when you think about some of the key challenges of investing in the private markets, things like access, things like information and data, the cost of investing in the private markets where essentially things like no-fee-no-carry co-investment or scale-driven discounts have been the true proven ways to bring down your overall fee burden, working with a group like StepStone makes a lot more sense than going alone.

Got it. Investor Day last week, you announced that you are targeting to double your fee-related earnings over the next 5 years, which equates to about a 15% or so annual growth rate. So can you talk about your growth algorithm? And what does one have to believe in order to see that 15%?

We spent quite a bit of time last Tuesday during Investor Day, unpacking the growth algorithms that led us to the statement and the message that we delivered last week, which was that we believe that there's a clear path towards doubling our fee-related earnings over the next 5 years. And culturally, it's worth mentioning, we didn't come forward and set that as a target right, or as a goal and then reverse engineer how to get there. Scott, Jason and I and other executives and the firm really characterize that kind of growth in AUM and fee-related earnings as the reward. If we do a good job with our clients, and we're serving them well, they'll reward us with additional trust and additional AUM. So it's really the reward, not so much the target. And so we did a bottoms-up, an assessment of our growth drivers, which are largely in place today. So what you need to believe is 2 or 3 things. The first is the managed account part of our business, which is roughly 2/3 of our fee-paying AUM is growing from 3 sources. The first source is we're sitting on about $16 billion of committed capital that's waiting to be deployed. And as it does get deployed, it will convert into fee-paying AUM, and that will happen over the next 3 to 5 years. So you just need to believe that we have the investment teams and the ability to deploy the $16 billion that's already been committed. The second thing you need to believe that our managed account business is -- that our clients are going to continue to re-up with us in a manner that's consistent with the past. The past has enjoyed a 90% re-up rate with our installed client base. And when they do re-up, they tend to re-up with a mandate that is maybe 20%, 30% larger than the prior mandate and/or they will bring forward an opportunity to expand into other asset classes. So if a mandate was in private equity and they say, "Hey, could you do something similar for us in infrastructure, real estate or private debt?" So what you need to believe is that our clients will continue to re-up with us and when they re-up, they'll expand. The third part of our managed account business that you need to believe is that we'll continue to add new clients. And we've demonstrated an ability to add new clients around the world each year. So, on the managed account front, it's about deploying capital that's already committed. It's about re-upping those existing clients and adding new clients over the next 5 years. The second bucket or the second algorithm relates to our co-mingled fund business. And we're now sitting on over 50 unique commingled funds. And what you need to believe there is that those funds that we already have established for the most part, will grow as successor funds are launched. And there's room to grow. The fund sizes that we manage are anywhere between $500 million to $3 billion. It's not like we have $15 billion, $20 billion, $30 billion funds and you have to believe that these guys are going to get out there and raise another $25 billion. No, these are $500 million to $3 billion. There's a lot of room for our commingled funds to grow, particularly on the institutional front. On the wealth management front, where commingled funds are also enjoying quite a bit of adoption and uptake is our inaugural retail product called SPRIM, which is sitting at about $1.3 billion, 2.5 years into its launch, followed by our venture capital and growth equity product called SPRING. And together, we're sitting on about $1.7 billion of fee-paying capital coming from wealth management. So what you need to believe there is that we're just going to continue to enjoy the success that we've enjoyed in the past with the success -- with the successor funds in the commingled space. When we combine those 2 growth algorithms that are already in place, you just need to believe that with growth in those areas we'll enjoy scale economies and there'll be some operating leverage and some margin expansion from those 2 growth drivers. So those are the 3 main growth drivers that we outlined in quite a bit of detail last week. Said differently, what you don't need to believe is that there's anything heroic going on here or anything inorganic that you have to believe going on here in order for us to achieve a doubling of our fee-related earnings over the next 5 years.

Just to dig in there, if I could, just to make sure I understand. So there is a margin expansion embedded into that expectation. Is that getting into the mid-30s? Or is it just modestly above where we are today? And then the other piece would be, is there anything from an NCI sort of impact in terms of taking on greater ownership of the subs, which was a question that some folks had coming out of Investor Day. Is that at all baked in? Does that impact the outcome?

Sure. As far as margins are concerned, when we took the company public a couple of -- 2 and 3 years ago, we had set an expectation for ourselves and for investors and sell side that we would hope -- we would expect to see our margins reach the mid-30s over the long term, that was 3 years ago. We're 3 years into it, and we've expanded our margins by 700 basis points. And we expect to see that to continue into the mid-30s over the medium to long term. We don't set a specific time frame on this, mainly because Scott and I and Jason Ment are constantly evaluating where we want to invest for growth versus how do we want to manage the business for profitability. So there is this put and take between managing for growth and managing for profitability. And we're always going to keep the optionality available to us and the priority on investing for growth. And that will lead to the economies of scale over time. But we're not going to set a specific target date, if you will, on when we reach the mid-30s for margins. As it relates to buying in the NCI, which is the ownership that our teams share with StepStone in their individual asset classes that won't affect our FRE margins at all. our FRE margins are already fully loaded across the platform where buying in NCI would impact the performance of StepStone's bottom line is in [ A&I ] in our cash earnings. And we would expect that, that, as we discussed during our Investor Day to occur over the medium to long term. and it's likely to occur through a series of exchanges in equity between StepStone holdings and the business units themselves. And it's likely to be done with equity as opposed to cash mainly to maintain that alignment of interest and that equity ownership and that entrepreneurial spirit that has gotten us to where we are today.

Great. Appreciate all the clarification there.

You're welcome.

At Investor Day last week, you also had this, I think, interesting case study showing how you've listened to clients over the last 15 years, and that's pushed you to expand the platform a bit to meet their needs. So the question is, curious what you're hearing from clients these days in terms of services and capabilities that you don't have or that you have that are maybe not as meaningful in terms of the contribution.

By far, one of our favorite slides of the entire day was a case study of one of our early clients. And it really began as a private equity advisory client. And over the course of the last 13-plus years, has increased 11-fold in terms of asset management. And not only in private equity, that this particular client also moved into real estate and infrastructure and led StepStone really to make the strategic choices that we made because they came to us and said, "hey, we love what you're doing for us in private equity. Can you repeat that for us in real estate and in infrastructure?" And that created a dilemma for us. We did not have the expertise, the core competencies in those asset classes to deliver the same value that we were able to deliver in private equity. So we went out into the market, and we brought on large, capable veteran teams with deep track records and networks in real estate, in infrastructure and in private credit. So we have a listen-first mentality and a listen-first culture in the organization, and then we follow up with a customized solution. What we're hearing today is you have a commingled fund solution in infrastructure for smaller and midsized investors. Infrastructure typically lends itself to much larger scale asset owners. But the smaller and midsized investor is looking for ways to access infrastructure. And so we came to market late last year with an infrastructure commingled fund, specifically targeting co-investments. That's a very exciting new development that was, again, the listen-first-act-second. The other thing worth noting anecdotally is the acquisition of Greenspring has led us to, again, listening first and acting second things that we would never have been able to accomplish independently of each other. For example, Greenspring was primarily focused commercially on the commingled fund business. They really didn't have a managed account business. What has happened is StepStone has now been able to land a number of significant managed accounts in venture capital that we otherwise would not have won with our VC and growth equity team currently in place. And vice versa, the launch of SPRING, this is the wealth management product for the accredited investor that Greenspring would never have been able to launch without StepStone's wealth management platform. So we're seeing real synergies by listening to what the market is looking for through the combination of StepStone and Greenspring. So those are a few examples. And Scott, I don't know if there's anything you wanted to add to what we're hearing from clients. But...

I think you've covered it. That's the bulk of it.

Great. Why don't we shift and talk about the mix of your business. If we look at it today, it's about 50% in private equity and 50% in non-PE verticals, credit, infrastructure, real estate. And also about -- we see about 70% of your fees or so are from clients overseas, which is actually a big differentiator from most of the peers out there. So my question is where do you see this mix of business heading over the long term?

Let me start with the asset class mix because as you just heard Mike say, there was a point in time not that long ago where we were 100% private equity. If you look back at -- and that was prior to 2014, if you look at 2018, we were probably 60% private equity and, today, we're 50-50. And that's despite the fact that we made a sizable acquisition of Greenspring, which sits within the private equity portfolio. And so part of what has driven that shift is exactly what Mike described is we went out and brought on those large senior experienced teams to lead our efforts in real estate, infrastructure and private credit. Those businesses have grown quite nicely over the last 6 to 8 years. We've laid out recently the trajectory that those businesses have been on relative to the private equity business during its first 6 to 8 years and has been on a remarkably similar trajectory, and we would expect that not only because they're growing off of a smaller base, but those non-private equity asset classes have been some of the faster growing parts of the market, we would expect that despite the fact private equity has continued to grow quite nicely. It will be outpaced by the real estate infrastructure and private credit businesses, meaning that we will have an even more balanced mix over time. And we credit those teams, those large experienced teams who we've created an incentive structure and alignment structure that encourages them to go out and grow and build their businesses over time. And the other thing I would add is one of the things that we noted after kind of year 6 to 8 in the private equity business is that certain things do become easier over time. You reach a point where not every single separate account or commingled fund is a first-time fund. You have the benefit of re-ups, you have the ability to expand client relationships. You have a more established tracker. And so from an asset class standpoint, we would expect even more balance over time as these other asset classes continue to grow. From a geographic standpoint or you could even look at the mix between separate accounts, commingled funds and advisory, and we like the diversification of the business, particularly at a time where there's certainly been a narrative around U.S. investors being more fully allocated and some of the growth opportunity coming from overseas. We like the fact that we've been active in these markets and have such an established client base in places like the Middle East, Asia, Latin America, Europe for us to build upon on a go-forward basis. We don't have targets in mind in terms of what that mix will look like. But the one thing we know, certainly after the last several years here, is the world around us will continue to change, and we think the diversified platform we built will position us to win in nearly any market environment.

Great. Why don't we shift and talk about fundraising. We continue to hear about a more challenging fundraising backdrop out there just given the denominator effect and limited realization activity weighing on LP liquidity. So just from StepStone's perspective, how do you see the environment? And what does it mean just in terms of the funds that you guys have in the marketplace and the timing and appetite to bring new funds into the market?

Yes. So we see it from a couple of different angles, right? So we spend a lot of our time working with clients on the LP side of the table. But to your point around some of the funds that we have in market or will be bringing to market, we also spend time fund raising. And so there's no doubt about it. It continues to be a challenging fundraising environment. It's not an impossible fundraising environment. I think particularly if you have strategies that are in high demand today. And to Mike's point earlier around our current fund size is leaving room for continued growth. I think we see that things can get done in the fundraising market today, but they're taking longer than they otherwise would have. And -- yes, one of the comments I've often made is there's just a lack of urgency right now. You have many conversations with LPs, who tell you committed to the strategy. I plan to commit but I want to come into your last closing. And so at some point, it just becomes a game of trying to build up the momentum to get to that final closing and wrap up your fundraising so that you can move on. To your question around the funds that we have in market and those that are coming back, again, it's taking a bit longer with those that are in market, but we feel fortunate to have several strategies that are in high demand. When you think about the sizable first closing on our real estate secondaries fund that we had recently, our private equity secondaries fund that's in market. Mike mentioned infrastructure co-investments. And so a number of strategies that continue to be in high demand. As for future fundraising, look, the reality is it will be driven by when those funds are fully committed and fully invested. With the slowdown we've seen in the deployment environment, that means things have probably been pushed out slightly. But many of those funds will continue to come back to market on schedule. So again, it's certainly resulting in a scenario where our teams are spending a tremendous amount of time on the road marketing. We've recently brought on a new Head of Business Development, which we think is going to be a great addition to the team over time here, but continue to managing through a tough fund raising environment.

Private wealth channel. Let's talk about that, growing focus of yours and for many others in the industry. You have 2 products already launched and on platforms. You're seeing some really strong traction there. Maybe talk about your approach to product and distribution and why your open architecture approach you view as a differentiating feature?

Yes. So it's a product and distribution. I'd start with the product. And as you can imagine, given our origins as a solutions provider and Mike's comment around this listen-first mentality, we spend a lot of time first listening to the various different wealth channels to understand the need in the marketplace. And then think about how we can leverage the StepStone platform to create a product and a solution that meets that need. And what we heard a few years back before we launched SPRIM was there was a need for a product that was available down to the accredited investor level, not wanting to have to deal with K1 reporting, not wanting to have to deal with capital calls, a need for quarterly liquidity. But importantly, because for many investors, this might be their single ticket for the private markets, you need to have instant diversification. That's diversification across vintage years, across strategies, across certainly underlying portfolio companies, but also across underlying managers. And I think one of the unique aspects of StepStone's platform is the open architecture multi-manager approach. I think it helps solve that equation I just described, whereby LPs want and need that diversification. But I think when you think about the GP community. In our view, there's no single GP that is the best at everything they do, every sector, every industry, every geography, every style of investment. And so one of the unique aspects that StepStone brings to the table when crafting a solution for the private wealth channel is the ability to bring our open architecture and multi-manager approach to the table. From a distribution standpoint, we've continued to grow the number of distribution partners, are now on about 180 or so different platforms. And that's a number that continues to grow. We've built out a private wealth team of now over 50 professionals that are helping to lead that effort. It's certainly a channel where you take a tremendous number of meetings and outreach and education, all of which with that team and with the broader StepStone platform, we are well equipped to provide.

From a product standpoint, the 2 products you have are both private equity oriented in the marketplace. And how do you think about broadening that out further into real estate infrastructure, credit? Which structures can make sense? How do you think about also providing some degree of liquidity in those asset classes?

Yes. Well, so again, so we started with SPRIM as a single ticket solution, we then looked at what are some of the areas in the market where there's a need for an additional strategy or product that the individual investor doesn't otherwise have access to and where StepStone, again, is well positioned to create that solution. And then some of the first ones that we sell are, one, venture in growth equity, which to your point, falls within the private equity asset class. Next up, and we've talked about the fact that we were on file with an infrastructure product as well as yet another area where there is limited competition in that market today. And we, with one of the leading infrastructure platforms feel like we are well positioned to meet that need. And so I think we will continue to look around the StepStone platform. Clearly, we are also active in real estate and private credit to figure out where there are opportunities for us to provide a differentiated solution for the private wealth channel. I mean, to your point around being able to provide liquidity, but also the ability to manage a product that doesn't call capital over time. But the important thing is that we've got a tremendous amount of deal flow and deal flow that is actionable and allows us to line up new investment opportunities when the capital is being raised but also build a portfolio that generates sufficient liquidity to meet potential quarterly needs as clients either look to rebalance or otherwise over time.

Why don't we change topics here and talk about capital management? You guys recently changed your dividend policy to have a recurring fixed dividend that grows with FRE, fee-related earnings, and also a special annual dividend that pays out the performance fees. So what led you to change the policy? What's been the feedback that you've heard from your stakeholders? And what should we expect in terms of the overall payout compared to the, I think, 84% or so that you had in fiscal '23?

Well, first and foremost, the feedback we've received from our stakeholders has been resoundingly positive. It's been -- we did a lot of research leading up to the decision. And there was just this growing sort of demand for how do we really learn to appreciate the performance fees part of our business. What we were experiencing was a couple of things. The first is fee-related earnings and performance-related earnings are fairly independent cash flow streams. The former being very predictable, very steady and growing, the latter being a little less difficult, a little harder to predict a little less -- a little more episodic, a little less stable. But when you merge the 2 cash flow streams and pay out a dividend, cash will unnecessarily build. And we are a very capital-efficient business. So having this cash build from the PRE side of the cash flow streams was becoming increasingly in focus at the Board level. So we hatched the concept of saying, why don't we bifurcate the 2 cash flow streams, and create a quarterly dividend that pays out the vast majority of our fee-related earnings, which we were paying $0.20 per share through fiscal '23, and then augment -- it's not a special dividend, it's an augmentation of a recurring dividend paid once a year linked to our realized performance fees. And so midway through last year, we announced the decision to pursue this approach. And the fourth quarter of our fiscal year ending March 31 was the first quarter in which we implemented the bifurcation of the 2 dividends. And paying -- being paid out this month in June will be 2 dividends. The $0.20 per share that's related to fee-related earnings, and $0.25 a share related to the accrual of what was not paid out in the $0.20 performance-related fees. Going forward in fiscal '24, you can expect to see the same thing. Our intention is to pay out the vast majority of our earnings, whether it's fee related or performance related. And the $0.20 per share that we had been paying out for the last 4 quarters is a good jumping off point as we head into 2024. And that will be augmented by a dividend that's paid in June of next year as we accrue and build our realized performance fees over the next 12 months.

Great. We're going to open up to audience Q&A in just a moment so get your questions ready. But first, let's talk about secondaries. It was mentioned throughout your Investor Day that you broadly expect market conditions to catalyze substantial deal flow activity across VC growth equity, buyout, and also real estate. So a question, why haven't we seen it yet? And what signs, if any, are you seeing that this is picking up? And what catalysts might help unlock the potential for a deluge of activity?

Yes. I mean, the reasons we're not seeing it yet or a catalyst that will unlock it, I think, vary a little bit by asset class. Where we are seeing and the signs that lead us to say that the top of the funnel has certainly picked up pretty dramatically. If I think about our private equity secondaries funnel, I saw a tremendous amount of activity in 2022. And if we were to extrapolate and look at the first 5 months of this year and assume similar levels of activity throughout the rest of the year, we would have seen 30% to 40% increase even relative to 2022 levels. Similarly, if I think about our venture capital business, really since Silicon Valley Bank, have seen a dramatic increase in the amount of LP secondaries on the market there. So tremendous top-of-funnel activity. You've seen less that's actually been executed. Although, I think that is starting to starting to change, either as some of the markdowns in GP portfolios have started to flow through, and therefore, the discount that one can offer are a bit more palatable to the seller as one driver of more deal flow actually being executed upon. The other, if I think about the real estate business, I think what we're going to need to see is some of the refinancing that we expect to come over the coming years, something like $500 billion of refinancings here in the U.S. in 2023. $2.5 trillion over the next 5 years. We think that's some of what is going to reset values. And as those maturities approach, clearly existing owners of real estate are either going to have to sell assets, fund assets or refinance and recapitalize assets, and I think that's particularly where our real estate secondary strategy comes into play.

Great. Do we have any questions here in the room? Just raise your hand, and we'll get a microphone. We have a question right here.

I apologize if this is sort of basic, but to your opening premise about what an LP might need your help with. I don't know if there's a particular asset class where you think that 5-person alternatives team, looking globally, is most overwhelmed or most needs your help in scouring and expanding landscape.

It's a good question. I think -- look, I think our view would be that really across all asset classes, they need our support, but maybe for different reasons and at different times. And I think certainly, when you think about the number of managers in the private equity and the venture capital space, and one of the things that we walked through at our Investor Day is just a very wide dispersion of returns between the large and mega buyout firms versus venture capital and small buyouts and the fact that much of our time is spent with our clients focus on the small and mid-market part of the market where there's both greater reward if you get it right in terms of manager selection but also a greater penalty if you do not. And so in terms of areas that we can add value, we spend a tremendous amount of time of what our private equity and venture clients, covering the thousands of underlying small, mid-market and venture capital managers. In areas like real estate and infrastructure today, it's a bit more of a concentrated GP base but you see many investors that are looking to, for example, go direct. And so in our infrastructure business, you see quite a bit of direct activity in the form of either co-investments or what we call investment partnering where LPs are clubbing up together, and those are strategies that many clients cannot pursue on their own. And so again, we see opportunities across asset classes, but maybe for slightly different reasons in each one.

Other questions in the room? Maybe we can talk about private credit. Talk about your positioning in the marketplace for private credit, how you approach sourcing, and how you might be able to capitalize on some of the dislocations we're seeing in the banking sector.

So our positioning is pretty similar to our positioning in the other asset classes, which is that we are one of the larger allocators in the private credit space, having deployed over $30 billion over the last 3 years. We have one of the larger dedicated investment teams with over 70 professionals. But if you think about the return profile in private credit, we're at a lower return, there's capped upside. You can imagine a lot of our time is spent on deal flow deployment, diversification and downside protection in the sense that we are of the view that important to generating the maximum number of investment return dollars as opposed to maybe being IRR-focused, requires that you get and stay invested efficiently. And then important to ensuring downside protection is really diversification and having a number of sort of restrictions in place to make sure that we are investing in some of the higher quality transactions in the marketplace. And the way we've tried to achieve that is similar to the rest of our business. We were active in co-investments and secondary and primary funds. In the case of primary funds, we've actually done in the private credit space is set up a series of separate accounts with over 40 different managers where we've negotiated a certain amount of investment capacity that is what helps us get and stay invested more quickly than simply deploying into private credit funds. I think that's one of the key differentiators. I think on a go-forward basis, expect to continue to supplement that deal flow with an increasing amount of co-investment and secondary activity, which would be quite similar to what we do across the private equity, real estate and infrastructure space. To your question on how do we capitalize on the banks pulling back. And I think there's a few different things. One, we would expect to see increasing deal flow as the private credit manager step in to fill the void that is created. But two, I think the pullback of the banks and the regional banking crisis really opened up the eyes of our clients and other LPs to the private credit opportunity. Even though they may have looked at the opportunity historically and said, well, are the -- is the strategy really proven and battle tested, I think today, they see it as a massive opportunity and one that they're looking to capitalize on. I think it's an opportunity for us to work closely with those clients.

Great. We'll have to leave it there. Mike, Scott thank you very much. Appreciate it.

Great.

Thank you. Mike. appreciate it.

Thank you, Mike.

Thanks, everyone.