Stepstone Group Inc.

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 4/5

Stepstone Group Inc. is a global private markets investment firm, focusing on providing customized investment solutions and advisory services to institutional investors, wealth funds, and high-net-worth individuals, primarily in private equity, real estate, infrastructure, and private debt.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Stepstone Group Inc. operates as an investment management and advisory firm, connecting investors with unique opportunities in private markets.

  • Revenue Distribution: The company’s revenue streams primarily from management and advisory fees, incentive fees, and allocations of carried interest. Revenue is primarily generated through contractual arrangements with clients and is dependent on the level of assets under management and the performance of these assets. Their main revenue drivers are:
    • Management and advisory fees are based on committed capital or net invested capital and may vary based on client investment allocations and contractual terms.
    • Incentive fees from focused commingled funds are based on a specified rate applied against client capital commitments during a defined performance period, or are typically calculated based on a contractual rate applied against net invested capital.
    • Carried interest allocations from limited partnership funds are related to their performance and are typically subject to a so-called “catch-up,” whereby all profits are first allocated to limited partners in their funds until their targeted return has been reached. After that point, StepStone may begin earning its share of profits, which is called “carried interest”.
    • Revenue is generally recognized at the point in time when services are rendered or the associated performance obligations are fulfilled.

  • Industry Trends:

  • The private markets are becoming more and more institutionalized, that is, institutional investors are increasingly interested in allocating capital in private markets. This has resulted in an increase in private markets’ assets under management over the past few years.
  • This is also a more fragmented and varied landscape of players. With new strategies and product emerging constantly, having a scalable business model and good data analytics is key to gaining and maintaining market share.

  • In the past two years, private market firms have been focused on raising capital, finding opportunities, and maintaining good investment performance, amidst rising interest rates and inflation, a potential recession, and geopolitical turmoil.

  • Margins: Stepstone boasts a 55% operating margin (2022), which is higher than its peers. It earns its revenue mostly through performance-based and management fees, which allows them to have this higher profitability. These fees are also contractual and predictable, resulting in good visibility on the revenue side. It has a low cost structure, which allows the company to be very profitable, which allows it to have more funds to grow and invest in further technology and improve its capabilities.

  • Competitive Landscape: The company operates in a competitive market, facing competition from other large firms such as Blackstone, Ares, and Apollo. The main differentiators for the company are its global reach, multi-asset class knowledge, focus on long-term relationship with clients, proprietary data, and strong investment track record.

  • What Makes STEP Different?:

Stepstone operates as a “solutions provider”, not simply a fund. This approach is differentiated compared to other players and has helped increase their client retention rates. * Stepstone offers solutions that are highly tailored to meet the client’s specific investment goals and mandates.

  • The firm has a global footprint, with 27 offices around the world.
  • Their tech is proprietary, with unique data on the market and insights for clients.
  • They boast long-term relationships with their clients, which lead to consistent revenue and AUM growth.
  • Their core investment strategies are in private markets: Private Equity, Private Credit, Infrastructure, and Real Estate.
    • Private equity: this is one of the key elements of the firm.
    • Real estate: the firm invests in a diversified portfolio of assets across geographies and risk profiles.
    • Infrastructure: it invests in infrastructure assets such as toll roads, utilities, and airports.
    • Private debt: It makes a variety of private debt investments and seeks to be a partner of the borrowers.
    • The firm provides integrated research, reporting, and technology capabilities to clients
    • The firm has also adopted an ESG framework in its investment decision-making process.

Financial Analysis

In the third quarter of 2023, StepStone exceeded consensus estimates due to higher revenue driven by robust fundraising activity, the demand from clients for strategic advisory solutions, and the performance of their co-investments.

  • Revenues: the company has shown consistent revenue growth in the last few years, even though recent market conditions have caused declines in equity and bond markets, which, in turn, caused its valuation to take a hit. Revenues are primarily driven by management fees and performance based fees, and has increased YOY and is a sign of good demand and execution. Revenues are expected to increase due to the increasing interest in the private markets.

  • Income Statement: The company’s revenue is primarily a function of fees based on assets under management, and they also recognize carry and performance-based revenue based on the success of the investments and the performance of the company. It is important to note the company’s recurring revenue is very significant, due to its lock-in relationship with its clients. The operating expenses mostly consist of compensation, professional services, travel, marketing and communication and general administrative expenses. Overall the company has maintained high margins over the years and is expected to improve its margins further.

  • Balance Sheet: From a balance sheet perspective, most assets are non-interest-bearing, which helps with return on equity. The company doesn’t rely too much on debt, and even when the debt levels go up for the company, they are offset by increased liquidity, thereby reducing the overall risks related to the balance sheet of the company. As of September 30, 2023, STEP had $1512 million in cash and cash equivalents, and only $221 million of net debt, a really good number for the company.

  • Cash Flow: Stepstone has a good amount of cash flow from operations, mainly driven by management and advisory fees, which are recurring and stable. The company has high CAPEX, which is primarily driven by software investments and technology platforms, which are key for their competitive advantages. The company generates a strong amount of cash flow, and after investments, it still has high cash flow available for the company to make acquisitions, reward shareholders through dividends or share buybacks, and for any business operations.

Moat Analysis

Stepstone has a narrow moat that will very likely persist for a very long time.

  • Intangible Assets: Stepstone has brand recognition in the private equity industry that is highly regarded and sought-after. Clients see it as a trusted partner and consultant for their investment needs and goals. They have a good reputation among peers and clients, which is beneficial for long-term performance. In addition, they have proprietary technology that gives them an edge compared to peers, since these proprietary platforms are unique to STEP, and cannot be replicated easily. The proprietary data and technology platforms are difficult to maintain, as they require constant innovation and capital investments, but they make up for a sizable competitive advantage. Finally, the company has several patents on their processes that prevent rivals from using their best operating models, thereby creating a technological moat.

  • Switching Costs: One of the primary reasons that STEP is able to maintain such high margins and stable revenue is due to the high switching costs associated with its business. Clients typically build a long term, deep relationship with their investment advisors, and it is difficult to switch to another firm, without undergoing a considerable amount of costs and uncertainty. Also, StepStone customizes their offering specifically to each client’s mandates, and this personalized touch enhances the relationship with clients, and makes switching to another firm very hard, unless something goes terribly wrong.

  • Network Effects: Stepstone’s global network provides a massive advantage for the company. It allows them access to different opportunities worldwide, in addition to enabling them to share their expertise globally, without any extra cost. This makes the firm attractive to clients, and reinforces its network moat.

  • Cost Advantage: The company leverages its size and scale to gain cost advantages compared to competitors. It is easier for them to invest in technology and data, and spread the costs over more assets under management, thereby generating more profit per client.

While STEP has several areas of strength, here is a look at the areas of weaknesses:

  • Legitimate Risks to the Moat and Business Resilience
    • Market Volatility: As an investment management firm, market volatility is a big concern, as any sudden dip in equity or bond markets can affect its assets under management and therefore affect its revenue significantly.
    • Competition: Competition is fierce in the financial world, and this can create fee pressures, and can lead to a decline in performance. The company operates with a very big player base, all of them highly capable of giving similar services as Stepstone and could potentially steal some of their market share, or force them to offer reduced prices, thereby damaging their profits.
    • Key Personnel: Stepstone’s success is driven by its top tier management and investment teams. Losing senior personnel or their key contacts can severely affect the firm’s ability to secure new deals.
    • Regulatory Risk: Financial regulations and compliance play a key role in the business. Changes in regulation can adversely affect the firm’s profitability and flexibility.
      • For example, changes in the taxation of carried interest could have a negative impact on the company.
    • Private Credit Risks: In case of companies in its private credit portfolio becoming bankrupt or not being able to honor their credit obligations, could lead to losses.

Understandability: 3 / 5

Stepstone’s business is not easy to understand, given the complexity of financial markets, complicated accounting, and the various revenue lines the company operates in, from management fees to performance fees. While the company’s business is fundamentally straightforward, it needs an in depth understanding of the financial industry and the various strategies that a private equity investment firm operates in, and this makes the company fall in the middle in terms of understandability.

Balance Sheet Health: 4 / 5

  • Stepstone has a relatively healthy balance sheet, as it has very strong liquidity positions, high book-to-market and debt-to-equity ratios are well within acceptable levels and the company has a high cash balance, compared to its low debt levels. The company’s cash position has helped it to maintain stability through turbulent economic cycles. These financial health metrics give a rating of 4 out of 5.

Recent Concerns / Controversies / Problems

  • Inflation & Interest Rates: The current interest rates and macroeconomic environment have been a cause of worry for Stepstone management, as the current conditions may impact the overall deal flow, and reduce investment opportunities. But the company has so far performed well during the current macro environment, which is promising.
  • Global Economic Uncertainty: Due to the various geopolitical risks around the globe, and the fear of recession, clients might become more risk averse, and deploy less capital in private market. A prolonged bear market will also affect the company’s ability to generate performance-based revenue. Stepstone has reiterated that the company is well-positioned for any possible downturn.
  • Regulatory Requirements: The company expects more compliance costs and operational complexities stemming from an increasing level of regulations over the private markets industry. This may affect the company’s profitability.
  • Competition for Allocations: Competition has intensified for investments, as many companies with higher capital allocations are targeting a finite number of investment opportunities. This may result in overpaying for assets and lower returns on investment.
  • Talent Retention: Due to the competition from other players in private markets, keeping hold of talented employees has become a challenge for the firm. They have mentioned steps to continue to provide a competitive package to attract and retain top talent.