StepStone Group (STEP) has gone public in an offering which was well-received by the market as modest earnings multiples (based on fiscal 2020 results) are combined with a solid long-term outlook for the company.
Unfortunately, the carried interest composition is very volatile, and even negative at times, as I have some long-term concerns about the business model preventing me from jumping onboard at a market multiple.
StepStone is a global private markets investment firm which focuses on customized investment solutions, advisory and data services to clients, which includes large pension funds, sovereign wealth funds, insurance companies and other wealth organizations, including high net worth individuals.
StepStone works together with clients to develop and build private market portfolios across asset classes such as private equity, infrastructure, debt and real estate. The company teams up with third-party fund managers in primaries, secondaries and direct investments (co-investments), and as of June 2020, it oversaw nearly $300 billion in private markets allocation. A minority of these are assets under management, while the majority of assets are under advisement, resulting in lower fees. This nearly $300 billion in total assets under management and advisory marks a steep increase from just a billion in 2007, demonstrating the long-term growth of the business.
In terms of asset classes, half of total assets under management are invested in private equity, with roughly a fifth allocated to private debt, infrastructure and the remaining into real estate.
StepStone and its underwriters initially aimed to sell 17.5 million shares in a range between $15 and $17 per share. Demand for the offering has been solid, as pricing has been set at $18 per share, resulting in gross proceeds of $315 million.
Upon the offering, there are nearly 95 million shares outstanding, which values equity of the company at $1.71 billion at the offer price. As none of the proceeds will benefit the company (as the money will be used to buy out previous interests), I peg net debt on a pro forma basis around $50 million, pushing up the enterprise valuation to $1.76 billion.
Amidst the increase in assets under management and under advisory, revenues have been trending higher in recent years. In the fiscal year 2018 (ending in March 2018), StepStone generated $264 million in revenues, comprised out of $141 million in management and advisory fees, and $122 million in carried interest allocation. The company reported very fat operating profits of $86 million and net earnings of $81 million.
2019 revenues fell slightly to $256 million, and this is only the result of carried interest falling to $64 million while the steadier management and advisory fees rose to $191 million. This modest and unexpected fall in carried interest meant that operating profits fell back to $62 million, as net earnings came in at $54 million.
The fiscal year of 2020 has been a very strange year, of course. With the fiscal year ending on March 31, the drawdown from COVID-19 was not yet reflected in the valuations. Management and advisory revenues rose to $235 million, as carried interest tripled to $208 million, resulting in operating profits of $149 million and net earnings of $132 million. Based on this profit number, earnings came in at $1.40 per share, valuing the operations at essentially 13 times earnings, that is at the offer price. With shares having risen to $25 at the first days of trading, the valuation has jumped to $2.4 billion, as this results in an earnings multiple of 17-18 times. It should be said that 2020 earnings have been very strong in relation to 2018 and 2019.
The first-quarter results for the fiscal year 2021 (ending June 2020) is dismal, as the impact of COVID-19 is now seen in the results. Management fees for the quarter came in at $63 million, for a run rate of $250 million. The issue is a $129 million reversal of carried interest allocation, in part offset by lower performance fee allocation to staff, as the company reported an operating loss of $51 million. While these are dismal results, we have, of course, seen a big recovery in the markets in recent months (with general market indices setting new records) which means that second-quarter results are likely very strong.
Unlike many large technology names, the revenue growth of StepStone is not that spectacular, and the company is actually quite profitable. In fact, even after the 50% run higher from the preliminary offering range, shares are trading at a market multiple. Note, however, that 2020 earnings were equivalent to the combined earnings reported in 2018 and 2019, while 2021 is set to become a softer year.
I am a bit in doubt about this public offering. I am impressed that the company has seen impressive and large gains in assets under management and advisory, and growth in management and advisory revenues is quite solid. On the other hand, there is a large carried interest composition (at around 50% of revenues in good years and negative revenue contribution in bad times), creating very volatile results, although the underlying trends are solid and indicate growth.
Risks include, of course, the general state of the economy and, related to that, the performance of the selected assets. This might not just result in negative carried interest, it might lead to termination of contracts as well. Of course, the long-term outlook is solid – the amount of assets held by its clients (notably pensions) will boom in the years to come, and StepStone seems eager to obtain a share of those larger mandates.
Here and now, I think shares are fairly valued, as I am not an avid believer in the business model of taking fees from these pension funds. These fees come on top of the costs made by the company’s clients and eat heavily into returns (certainly in a zero or low interest rate environment). All of this makes me extremely cautious, as I have a personal view that in the long run, this industry might be squeezed similarly, as ETFs have overthrown the traditional investment community.
I look forward to continued performance in the coming quarters. Yet, despite a reasonable current earnings multiple, I feel no urge to chase the shares here.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.