StepStone Group Inc. (NASDAQ:STEP) Q3 2023 Earnings Call Transcript

StepStone Group Inc. (NASDAQ:STEP) Q3 2023 Earnings Call Transcript February 9, 2023

Operator: Greetings and welcome to StepStone Fiscal Third Quarter 2023 Earnings Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Seth Weiss, Head of Investor Relations. Thank you, sir. You may begin.

Seth Weiss: Thank you. Joining me on the call today are Scott Hart, Chief Executive Officer; Jason Ment, President and Co-Chief Operating Officer; Mike McCabe, Head of Strategy; and Johnny Randel, Chief Financial Officer. During our prepared remarks, we will be referring to a presentation which is available on our Investor Relations website at shareholders.stepstonegroup.com. Before we begin, I’d like to remind everyone that this conference call as well as the presentation contains certain forward-looking statements regarding the company’s expected operating and financial performance for future periods and our plans for future dividends. Forward-looking statements reflect management’s current plans, estimates and expectations and are inherently uncertain and are subject to various risks, uncertainties and assumptions.

Actual results for future periods and actual dividends declared may differ materially from those expressed or implied by these forward-looking statements due to changes in circumstances or a number of risks or other factors that are described in the Risk Factors section of StepStone’s most recent 10-K. These forward-looking statements are made only as of today, and except as required, we undertake no obligation to update or revise any of them. In addition, today’s presentation contains references to non-GAAP financial measures. Reconciliations to the most directly comparable GAAP financial measures are included in our earnings release, our presentation and our filings with the SEC. Turning to our financial results for the third quarter of fiscal 2023, we reported a GAAP net loss of $13.6 million.

The GAAP net loss attributable to StepStone Group, Inc. was $6.9 million. We generated fee-related earnings of $39.0 million, adjusted net income of $31.2 million, and adjusted net income per share of $0.27. The quarter had no impact from retroactive fees. This compares to retroactive fees in the third quarter of fiscal 2022 that contributed $1.2 million to revenue and $1.1 million to fee-related earnings and pre-tax adjusted net income. Before turning to Scott, I am excited to announce that we will hold our first Investor Day on Tuesday, June 6 in New York. We have grown and evolved since our initial public offering 2.5 years ago and we look forward to covering our progress and introducing several of our key business leaders who are instrumental in driving our growth.

We will share further details as the event approaches. I will now hand the call over to StepStone’s Chief Executive Officer, Scott Hart.

Scott Hart: Thank you, Seth and good afternoon everyone. We delivered strong performance in the calendar year 2022 that is true whether you look at the investment performance we generated for clients, which continue to outperform the public market equivalents or the solid financial results we delivered to our shareholders. Turning to those financial results on Slide 5, we earned $31 million in adjusted net income for the quarter or $0.27 per share. This is down from $49 million or $0.42 per share in the third quarter of last year driven entirely by lower performance fees for which realizations are dependent on capital market activity. Importantly, our fee-related earnings continue to grow at a strong and steady pace, reflecting the durability of our core business, while our balances have accrued carried investments remain strong.

For the quarter, we generated $43 million of fee-related earnings, up 16% versus the prior year’s quarter. This earnings growth is driven by strong capital formation and continued deployment across asset classes, geographies and commercial structures. We finished the quarter with $134 billion of assets under management and $83 billion of fee-earning assets. The diversification of our platform and the specialized nature of our offerings give us the critical edge, particularly in today’s environment. Given our position as one of the largest investors in the private markets, I would like to take a moment to speak to the market environment and how we are positioned. As we are all aware, 2022 was a challenging year for capital markets. While private assets are not immune to broader market pressures, they have generally fared significantly better than their public equivalents.

Examining major events that spurred past cycles, including dotcom bubble, the global financial crisis and COVID, private markets experienced only a fraction of the peak to trough public market drawdown. Yet in each of these cases, private markets captured 100% or more of the subsequent recovery. Its asymmetric risk capture is a key feature that drives private assets outperformance and StepStone is well positioned to take advantage of opportunities in any market environment. Specifically, our extensive toolbox across primaries, co-investments and secondaries enables us to play offense or defense by partnering with the best managers in the highest quality investments. Pivoting back to the current environment, we are observing softer fundraising compared to the elevated activity over the last several years.

However, demand for secondaries as a means to capture discounts and co-investments as a cost effective access point remains robust. In secondaries, industry-wide deal activity topped $100 billion in 2022 trailing only at the record volumes from 2021. We anticipate the coming year’s volumes to remain strong. As a reminder, StepStone is a leader in secondaries with active comingled funds and managed accounts in private equity, venture capital, infrastructure, private debt and real estate. Our capabilities and secondaries are critical in delivering strong returns, particularly in challenging markets and have been key to our ability to launch private wealth products. Secondary volume naturally lags primary capital raises and is also a function of investments currently in the ground.

Private market fundraising has averaged well over $1 trillion a year since 2016, which compares to an average of just over $500 billion in the 6 years prior, while unrealized private asset value stands at approximately $10 trillion or roughly double the value from just 3 years ago. With more assets available to trade, the backdrop for secondaries is very promising. On LP-led deals, the accelerated fundraising cycle from the last several years, combined with a slower pace of distributions and declines in public market valuations have resulted in some being overallocated to private markets. We expect this will lead investors to utilize the secondary market to rebalance their portfolios. On GP-led deals, secondaries are no longer just a mechanism for managers to restructure legacy funds.

Top quartile managers are increasingly looking at the secondary market and continuation vehicles to capture future value from high conviction assets. Moving to co-investments, this remains one of the few ways to mitigate fees in the private markets without sacrificing quality. As a result, LP demand continues to be very high. The key to success is a strong, high-quality sourcing funnel to allow for discriminating asset selection combined with our superior data, due diligence insights and underwriting capabilities to drive better investment decisions. Shifting to trends by asset class, in private equity, we expect to see a growing divergence between those who have maintained discipline and those that have simply been riding the market tailwinds.

Tougher capital market conditions have led to a moderation in deployment and a less favorable exit environment. We are starting to see a valuation correction across certain sectors, coupled with slowing buyout transaction activity in response to market uncertainty and wide bid-ask spreads. Given the historical relative outperformance of down-market vintages, we believe private equity investments made in the coming years will prove to reward those with available capital. Furthermore, we expect that the denominator effect may catalyze a pickup in LP secondary buying opportunities with favorable discounts while general partners may look to generate liquidity in a challenging exit environment through GP-led secondary transactions. In Venture Capital, performance of public technology stocks has been among the worst in the market and headlines of tech layoffs appear to be a daily occurrence.

Despite the day-to-day volatility of the public tech sector, Venture Capital has proven to be a durable sector given its ability to capitalize on long-term structural growth trends. Great companies are created in all market cycles. The best vintages of Venture Capital performance came during the aftermath of the global financial crisis in the early 2010s and after the recession of the 1990s. We believe the next few years will provide a highly attractive entry point. Furthermore, the venture capital secondaries market is becoming much more active. There are well over $1 trillion of unrealized venture assets and vintages from 2018 and earlier, which we anticipate will spur an acceleration in BC secondary deal flow. We have the largest venture secondaries fund in the market today and we believe we are well positioned to continue to benefit with future funds.

This interest in venture and growth equity is shared by our clients. Last week, we hosted our Venture Capital Annual Meeting, where we had nearly 400 clients attend. While venture portfolios have been impacted, there is growing optimism about the go-forward investment opportunity. Moving to private debt, we generated positive returns in 2022 and the environment remains favorable. The defensive characteristics such as cash income, senior positioning the capital structure and conservative underwriting makes the asset class an all-weather investment strategy. Further, given primarily floating rate payments, our private debt offering provides protection against rising interest rates. We expect industry-wide deployment opportunities may moderate as less M&A volume and a slower pace of refinancing impact volumes, but our ability to dynamically pivot allocations among sponsors allows for consistent deployment, thereby reducing the cash drag and improving total returns.

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Real assets have proven to be resilient through market cycles. Many infrastructure and real estate cash flows are linked to inflation, providing a hedge against one of the biggest market risks today. We have products in both asset classes that are purpose built for the current environment. Infrastructure has been our fastest growing asset class in the last 12 months and that growth has come without the benefit of a flagship comingled product. We are now in market with our first infrastructure comingled co-investment fund for which demand has been very healthy. In real estate, manager-led secondaries present a unique opportunity in today’s environment. As debt matures, equity gaps are likely to catalyze recapitalizations of high-quality assets.

This is an area in which we thrive. We are currently in market with our flagship real estate product, which is a special situation manager-led secondaries fund. We expect attractive opportunities to deploy capital from this fund in the current environment. I will now turn the call over to Mike McCabe to speak about StepStone’s fundraising and fee-earning asset growth in more detail.

Mike McCabe: Thanks, Scott. Turning to Slide 7, we generated $18 billion of gross AUM inflows during the last 12 months, with $6 billion coming from our comingled funds and $12 million from managed accounts. Slide 8 shows our fee-earning AUM by structure and asset class. For the quarter, we grew fee-earning assets by $3 billion, largely driven by healthy deployment across several SMAs, activations of our PE secondaries fund and our multi-strategy Global Venture Capital Fund as well as incremental closings in comingled funds and evergreen private wealth offerings. Offsetting these additions were over $2 billion in the distributions line from separately managed accounts. As a reminder, distributions include exit activities, expiring mandates and step-downs in fee base.

The third fiscal quarter was an exciting period for our private wealth platform. SPRIM, our evergreen private markets fund for our credited investors continues to generate strong monthly subscriptions with de minimis redemptions of just over 1% for the quarter. Additionally, we launched offshore parallel and feeder funds in Europe and Australia and we executed our first close of SPRING, our private venture and growth fund for qualified clients. Aggregate subscriptions across these products were over $300 million during the quarter, bringing total AUM to over $1.3 billion on our private wealth platform. Our investment performance continues to be very strong with SPRIM generating a 30% annualized return since inception and SPRING off to a very strong start since its launch in November.

As Scott referenced, our leading secondaries platform is a key differentiator for these products, allowing us to efficiently deploying capital in a diversified manner with strong returns. Looking over the last 12 months, we have grown fee-earning assets by $12 billion or 16%. We are very pleased with this result given the current market environment, which impacted the timing of fundraising for all industry participants, particularly in the second half of last year. Going forward, we have not changed our expectations around the target size on current funds in the market nor do we anticipate a delay in launches of subsequent funds. The determining factor on launching a new fund is not the closing of a prior fund, but rather the deployment of a prior fund.

We pride ourselves on our discipline of steady deployment over a multiyear horizon. We have sufficient committed capital in our funds in market and expect a healthy pipeline of deal flow to continue deploying at attractive opportunities. This means our timeline for future comingled fund raises and separately managed account re-ups are largely unchanged. To this point, undeployed fee-earning capital stands at $14 billion, down from the previous quarter, driven by activations of our PE secondaries and multi-strategy global venture capital funds, plus deployment of committed capital in separately managed accounts. We have spoken in the past about the benefit of built-in and highly visible growth that comes from undeployed capital. Even more important is the opportunity that dry powder presents to drive returns.

Selective and disciplined investments in down markets have historically delivered the best performing vintages. Our dry powder, including this $14 billion, positions us extremely well to capitalize on today’s environment for our clients. Slide 9 shows the evolution of our management and advisory fees. We generated a blended management fee rate of 54 basis points, which is higher than prior years due to a mix shift toward comingled funds from the contribution of our expanded venture capital platform. We generated well over $4 per share in management and advisory fees over the last 12 months, representing an annual growth rate of 25% since 2018. We have produced this growth in an extremely capital-efficient manner, which should allow us to distribute the vast majority of our adjusted net income to shareholders.

As we discussed on our last earnings call, we are aligning our capital distribution approach to our business model. Our payouts will include a quarterly dividend that is generally tied to our fee-related earnings, augmented by an annual recurring supplemental dividend tied to realized performance-based earnings subject to Board approval. For our first three quarters of fiscal 2023, we have declared an aggregate of $0.60 per share in dividends, which represents nearly 100% of our fee-related earnings available to common shareholders. We plan to communicate and pay our supplemental dividend at the conclusion of our fiscal year. And with that, I’d like to turn the call over to our CFO, Johnny Randall.

Johnny Randel: Thank you, Mike. I’d like to turn your attention to Slide 11 to speak to a few of our financial highlights. For the quarter, we earned management and advisory fees of $129 million, up 21% from the prior year. The strength in revenue was driven by continued growth in fee-earning assets, including the activations of comingled funds in the quarter. We now have a full year of Greenspring in our results, so the year-over-year quarterly comparisons are on the same basis. Profitability remains very strong as we maintained an FRE margin of 33%, consistent with the last quarter, but down from the year ago quarter’s margin of 35%. We did not receive any retroactive fees in the current quarter, whereas retroactive fees in the year ago quarter benefited margins by approximately 1 percentage point.

Shifting to expenses, compensation was up $3 million sequentially driven by increased headcount, incentive payments related to the activation of comingled funds and the timing of year-end bonus accruals. G&A also increased sequentially, driven partially by expenses associated with our StepStone 360 conference, our annual Private Markets Investor Conference, which we held in person this year after holding the previous two conferences virtually. With compensation changes effective January 1, we expect a step up in the expense base next quarter. Gross realized performance and incentive fees were $19 million for the quarter, down versus prior periods as realizations have moderated, consistent with the expectations that we previously communicated.

We anticipate realized performance fee levels to remain modest in the near-term. Moving to Slide 12. Adjusted revenue per share is flat for the first three quarters of the year. We had a 24% growth in per share management and advisory fees, offset by a 37% decrease in per share performance fees. Speaking to the longer term, adjusted revenue per share has grown by 27% compounded annual rate since fiscal 2018. Shifting to our profitability on Slide 13, fee-related earnings per share has grown by 26% in our first three quarters. The increase was driven by growth in management and advisory fees and by margin expansion. Looking over the longer term, we have generated an annual growth rate of 44% and fee-related earnings per share since fiscal 2018.

Our year-to-date ANI per share is down relative to last year but has increased at an annual rate of 33% over the long-term period, driven by robust growth in both fee-related earnings and realized net performance fees. Moving to the balance sheet on Slide 14, gross accrued carry finished the quarter at approximately $1.1 billion, which is roughly $60 million lower than the previous quarter. The decrease is primarily driven by the reduction of underlying valuations during the September 30 period. As a reminder, our accrued carry balance is reported on a one quarter lag. Our own investment portfolio ended the quarter at $139 million, with the increase from the prior quarter driven by a seed investment into SPRING. Unfunded commitments to our investment programs were $87 million as of quarter end.

Our pool of performance fee eligible capital has grown to $60 billion, and this capital is widely diversified across multiple vintage years and 175 programs. 62% of our unrealized carry is tied to programs with vintages of 2017 or earlier, which means that these programs are largely out of their investment periods and are in harvest mode. 56% of this unrealized carry is sourced from vehicles with deal-by-deal waterfalls, meaning realized carry may be payable at the time of investment exit. This concludes our prepared remarks. I’ll now turn it back over to the operator to open the line for any questions.

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Q&A Session

Operator: Thank you. Our first question comes from Ken Worthington with JPMorgan. Please proceed with your question.

Ken Worthington: Hi, good afternoon. Thanks for taking the question. Maybe first on distributions, they were elevated as you mentioned, for the quarter, and you mentioned that a lot goes into SMA distribution. So can you talk a little bit about what was driving the elevated distributions this quarter? And as we think about the outlook for expirations and other things that you have visibility on for 2023 €“ calendar 2023, anything that sticks up that we should be aware of? Thank you.

Scott Hart: Sure. Thanks, Ken, for the question. So as you heard Mike say in the prepared remarks, we did have about $2 billion running through the distribution line there, and he mentioned what some of those drivers might be between realization, step-down in fee rates as well as expirations of existing accounts. We had a pretty normal level of activity across most of those different €“ most of those different drivers. The exception that drove the higher number this quarter was the expiration of an account, specifically in our infrastructure business with a client that we continue to work with in a variety of different ways. And I would just highlight that from a fee standpoint would have been something that had a well below average fee rate associated with it. So that is something that’s going to happen from time to time, particularly with accounts that may pay, for example, on committed capital throughout the life of the vehicle there.

Ken Worthington: Great. Thank you. And then just sentiment by your clients, your scale across multiple asset classes, you’ve got a lot of diversity by client, by geography. So we’d love to hear your insights, particularly in terms of how you see investors altering their asset allocation between private equity, real estate, infra and credit. So I think credit has €“ we’ve heard universally we’re seeing increased allocations, but there is definitely concern about allocations to real estate. So any color that you might have? Thank you.

Scott Hart: Yes, sure. I’ll start and others may want to jump in here as well. But I think you’re right. I think we’ve got an interesting perspective, not only because of our activities across the different asset classes within the private market. But frankly, because of the position where we act as both in LP working with our clients as well as GP out there, fundraising amongst LPs on a day in and day out basis. Look, I would say sentiment continues to be pretty balanced, hard to generalize in some cases because for every client that we have today that may be slightly decreasing their allocations coming into 2023, there are a similar number that are maintaining flat or slightly increasing allocations. I think that the sentiment is or the understanding amongst LPs is that these are vintage years that they don’t want to miss out on.

And there is an understanding that commitments that are made today are not going to be drawn down immediately and therefore, will ultimately impact your allocations over the coming years here. And so I still see a fair amount of activity. I expect that some of that activity will be more balanced throughout the course of the year, whereas over the last few years, much of it has been concentrated in the first half of the year. I think today, there is probably less of a sense of urgency or rushing into final close of funds that may drive some of that first half activity. And look, I think you’re right to highlight the interest in areas like credit, but I would say across the other asset classes where we operate, it’s not so much that we see a lack of interest in the asset class at large, you may be seeing a shift in where the interest is within that asset class.