How Dental Practice Transitions Have Changed

The private sale is based on constructs that are still relevant today. Typically, about 79% of annual collections would be the run rate.

In the last six years or so, however, private equity has increasingly moved into and consolidated the dentistry space. In dentistry, private equity is commonly referred to as DSOs.

Private equity has been involved in just about every other sector in the world, especially healthcare, which includes dentistry, veterinary medicine, optical, and even hearing.

Private equity uses leverage to arbitrage or make a spread over businesses that they buy. They've used the low cost of capital to leverage their large spread of businesses. It's important to note that they did this at a time when the cost of capital was low (more on this below).

It’s low cost because the Federal fund's interest rates were next to zero, which is the average run rate for general bank financing.

If you received bank financing two or three years ago, you would probably be well below four percent. Many people received below three percent on home mortgages. That's a historically low cost of capital.

That's why private equity has done so well and expanded into many industry sectors, but not always in a good way. In fact, if you go back to the 1980s, these private equity firms were doing the same thing, and it turned out very badly.

Why Leveraged Buyouts Only Work with Low Interest Rates

In the 1980s, there was a dramatic surge in leveraged buyout (LBO) activity financed by junk bonds. The key observation is that they were leveraged buyouts. They used leverage. Private equity, like DSOs, brings very little of their own money to the table.

Private equity uses other people's money, including the equity of the business sectors that they're buying. 

But the cost of capital has changed dramatically in the last 18 months. We have never seen this rate of change. It’s not that the rates are the highest we’ve ever seen. No, we’ve seen higher in the 70s. It’s the rate of rise that is significant here. The rate at which interest rates have risen has never been seen before.

We haven’t yet felt the full effects or seen all of the consequences of this rapid change in interest rates. Over the next year, we'll start to see the effects more clearly.

The marketplace is still very complacent about this. In the financial markets, even real estate, there are still people syndicating real estate equities based on the model that worked so well.

The trend of private equity through DSOs aggregating dental practices and providing these bigger-than-life multiples over the last number of years has been a strong draw for many new doctors, as it should be. You should investigate this for yourself.

I’m not against DSOs or private equity except when I believe they're doing more harm than good. Not everybody falls into that category, but in general, there's a propensity for these leveraged buyouts through private equity and DSOs to ride on the back of the seller and the seller's business.

When the market is going up, and the cost of capital stays low, there is no issue. Everyone wins. You don't see problems in the marketplace until something shifts.

The Market has Shifted

Today, we are seeing lawsuits against certain DSOs for not paying their bill. Certain DSOs are throwing in the towel. They’re reneging the “promises” they verbally gave doctors. But when you look at the fine print of the actual agreements, their attorneys very astutely built these structures to protect them, not you.

If you got in early on this trend of leveraged buyouts, it probably turned out well for you. You received your money, and the agreement went on as planned.

The same is true in real estate. If you invested in almost any real estate as an operator or investor in the last 14 years before the last year and a half, you've done well.

However, the model has changed in the real estate and private equity market. And it’s still changing today.

Private equity is not stupid money. They know what they're doing, and they are shifting more of the risk on you, the seller, the doctor.

As an inducement, DSOs are still promising high multiples, higher than you could get in a private sale. But a large portion gets tied up on the back end. There are constraints in the clauses. It is the things you don't understand or look at that get you into trouble.

I find that very few doctors and their advisors look at the financials of potential DSOs backed by private equity to see what their balance sheet looks like. In some cases, it is very difficult to do so due to a lack of transparency. 

We look at the financials of the operator/sponsor in real estate. We always do our due diligence on the operators and look at their balance sheets.

I personally want to see the cost of the capital they use, their terms, their asset-to-liability ratios, etc. I want to know who I’m investing with and what I'm dealing with.

Anyone can talk a great game, but I want to see what's behind the sponsor. If you're not doing this much due diligence with your potential DSO private equity exits, you might not get what you were promised.

Today, most DSOs are leaving the seller on the hook for their backend multiple, and doctors are getting paid less and less upfront while the backend multiple is “promised” but not guaranteed.

It used to be 80% on the front end, and then DSOs shifted to 70%. Then, it was 60%. Soon, it will be 50%. DSOs are also pushing back their “recaps” further down the road. 

DSOs have been able to pay exorbitant multiples in the past by refinancing (using recaps) over and over, typically every 24 months, to pay off the previous buyouts. Now that interest rates have risen, refinancing costs much more. DSOs will not refinance unless they are forced to, which means a delay in your recap or backend multiple. 

Once DSOs are forced to recap, they will lose so much money that you might not even get a backend multiple. The same thing is happening in real estate. This is the current marketplace.

Private Equity and DSOs Don’t Know How to Run Businesses Profitably 

Nobody, including private equity and DSOs, wants the market to change. They want to flip their capital and make money quickly. The longer they have to wait and actually operate or manage the businesses they bought from doctors like you, the worse it gets for them.

The high cost of capital drags on their profitability and EBITDA, especially when most, not all, are not good operators. They are great flippers, arbitrators, and financialization platforms, but most of them don’t know how to operate/manage a business profitably.

If you're in bed with a DSO like this, you should be concerned. Your practice may be successful.

You may be doing a great job or have done a great job, but you're now diluted with many other practices they bought.

All of these practices affect their balance sheet and the DSO's profitability. So, while you're waiting for that recap, if the people who will loan them money or buy the next tranche of practices from them are looking at their financials, and their financials don't look good, guess what? You're stuck. 

You have to ride it out, and you will most likely have to ride it out longer than you thought if you want even a chance of getting the multiples that have been promised.

Last Thoughts: Seek Caution and Expertise

This is a time of caution. It’s time to do much more due diligence before you sign on the dotted line. It’s crucial to seek others who have traversed this kind of marketplace before or are in the middle of doing so. Seeking expertise and guidance from the right people has never been more pertinent.