“I either win or I learn.”
~Dan Sullivan, Founder of Strategic Coach
I believe there are going to be a lot of people who learned a lot coming out of this decade.
For around the last 12 to 18 months, we’ve been living in the early stage of a new cycle of the DSO Economy – one that I’m going to refer to as the era of “Zombie DSOs.”
I’m going to refer to it that way because these are businesses that are on life support; burdened by massive debt that’s about to explode; and unable to generate any further expansion of profitability. They can’t “grow” because they can’t borrow any more money, and they can’t “go” because recap valuation multiples don’t justify an overall exit to an acquirer.
They’re just limping along…for now.
So, how did we get to “now?”
Private Equity Fund “Lifecycle”
A typical Private Equity Fund has around a 10-year life cycle broken up into 1 to 2 years in the beginning of raising investment into the fund, and 1 to 2 years at the end in preparation to go to market in order to divest of the assets (“harvesting”) to return money to investors. The middle 6 to 7 years is spent acquiring and improving assets (“building the business”).
Banks, Lenders & Private Credit
Private Equity uses limited investor capital backed by debt to create a war chest of cash to make acquisitions. Banks and non-bank lenders (“Private Credit”) loan money to businesses on a Debt-to-EBITDA ratio. Banks and non-bank lenders are risk averse, so the Debt-to-EBITDA ratio they’re willing to tolerate (“Credit Boxes”) can expand or contract due to changing macro-economic conditions.
Businesses & Borrowers
Private Equity-backed businesses typically borrow money from lenders on some sort of variable rate structure with a balloon payment at the end of some period of time. It’s a lot like borrowing money for a house on a 10-year “Interest Only” structure. We make monthly payments based on the floating interest rate, but pay no principal until the balloon payment is due at the end of the 10-year term. Most people who buy a house on an interest only structure intend to sell it before the ballon payment comes due. In much the same way, a PE-backed DSO intends to “recap” before the balloon payment comes due.
Valuation & Cash Flow
Valuation multiples are inversely correlated to lending rates: higher borrowing costs mean lower valuation multiples and vice versa. And higher borrowing costs equate to higher monthly payments, which results in lower overall free cash flow. Put another way, if a DSO borrows money at a high rate to buy a practice at an irrationally high valuation, then they have to create extraordinary clinic-level improvement to yield positive free cash flow after debt service.
History
Coming out of the Global Financial Crisis in 2009, we saw the proliferation of PE-backed DSOs for numerous reasons: healthcare services has historically been in the top 3 or 4 areas of interest for PE investment; dentistry is the least consolidated of all healthcare services; it has the least amount of government payer influence with a very high cash-payer component; and lending rates were dramatically low (Fed Funds Rate ~.10% in Jan 2009).
With greater velocity comes greater returns which creates greater awareness and interest, so there was a rush of entrants into the dentistry sector in the years 2017 to 2019. If they are representative of a typical 10-year fund cycle, these 2017 to 2019 “vintage” funds should be in the market to divest of assets and return money to investors right now. Most are in market, but few have returned any invested capital.
Recent History
Coming out of the Pandemic, there were a lot of practice owners who didn’t want to own practices, and there were a lot of PE-backed entrants into the space who wanted to buy a lot of practices, but they had no defined way of generating revenue, creating operational efficiencies, or improving profitability. These were “aggregators, not operators” in nature and they were willing to pay irrational premiums for successful practices. They wanted to “flip the house” before the balloon payment came due. They haven’t been able to do so.
Recognizing this recent appreciation of selling prices, many successful practice owners did not want to take a discount on the value of their business, so they often took the highest offer regardless of who the buyer was or what their investment thesis around value creation might’ve been. Many buyers looked to acquire practices generating a high-level of EBITDA; however, a practice that is already generating at or near optimal performance is a practice that is hard to improve. This wasn’t much of a focus in a post-Pandemic world because lending rates were once again incredibly low (Fed Funds Rate < .10%) and Debt-to-EBITDA credit boxes were highly advantageous to borrowers.
Current Events
Between March 2022 and August 2023, the Federal Funds Rate escalated quickly by over 500% (~450 “basis points”) and the Debt-to-EBITDA ratio of lenders shrunk dramatically. Post-Pandemic “Credit Boxes” were reportedly in the 5-6X Debt:EBITDA range and ended up in the 3-4X range 18 months later. To put that into perspective, if a PE-backed DSO has $25M in EBITDA, they just lost $50M in available acquisition capital to spend.
Now the only way to gain more acquisition capital is to create more EBITDA, which means growing revenue at a practice level or reducing costs at a corporate level. Many PE-backed DSOs acquired high-performing practices, so there is little revenue generation or cost reduction to be gained at a practice level. And if they can’t generate practice-level financial performance increases, then making cuts to their largest expense line item comes next. This explains the waves of layoffs in so many DSO Corporations over the last 24 months. The road to prosperity isn’t paved by headcount reduction.
The Walking Dead
Due to shrinking credit boxes, many PE-backed DSOs no longer have any capital to deploy for acquisitions, so they can’t grow their footprint.
Due to the rise in interest rates, many PE-backed DSOs are struggling to create operational free cash flow. And if they cannot maintain agreed upon levels of cash reserves on their balance sheet, then they are in jeopardy of breaching covenants with their lender(s).
Due to both shrinking credit boxes and increasing interest rates, enterprise-level valuation multiples have come down significantly, so a new Private Equity fund desiring to enter the Dentistry Sector is no longer willing to pay the high multiple of entry that we saw 6 or 7 years ago.
If you can’t grow the business and you can’t improve the business and you can’t divest of the business, then what do you do? You become a Zombie DSO.
Ticking Time Bombs
There are a few further points of jeopardy to be very concerned about. The debt structures of these companies are variable rate, so the amount of interest a borrower pays increases when the rate goes up, and they are, in essence, “interest only” – meaning no premium is paid until the balloon payment is due or the loan is paid off in its entirety prior to term. If a Private Equity fund has a lifespan of around 10 years, then it’s logical to assume that the term on most of the debt would be less than or around 10 years, so if your DSO launched in that 2017 to 2019 window, then the full amount they borrowed at a maximum-leverage credit box would be coming due…imminently.
For the original sellers of high-value practices, almost all likely rolled 20-40% of the sale price into equity in the acquiring company with an expectation of a 3 to 5-year work commitment. That work commitment is most likely now culminating at a point in time when a Zombie DSO can no longer create any additional value and has little hope of a successful acquisition by a larger entity. The seller’s equity value has likely been dramatically diminished and most likely cannot be redeemed without a further work commitment.
The original outside investors in Private Equity Funds (“Limited Partners”) have an expectation around total return (“multiple of invested capital”) as well as timeframe (typically 5-7 years). While these funds are “private” in nature and these investors are “limited” in terms of risk and influence, the investors do have some sway in terms of how their investment might or might not be retuned to them. If a company in a fund (a “DSO” for example) cannot be sold, it might be rolled into another fund (a “continuation vehicle”) with a different horizon in order to buy more time for the market to rebound or for operational improvement to be achieved. This could also free up some cash to return to the original investors in the fund, but likely not to the operators and equity holders of the business itself.
Truly distressed DSOs that aren’t really part of an overall investment “fund” are highly exposed because the business basically stands alone as an asset and cannot be combined with any others in a portfolio. In this case the primary owners or investors are simply looking for a way to get out – maybe even with no appreciation of their original investment or a minimal loss. In this situation, they’re looking for a company to acquire the DSO for some amount that satisfies the debt obligation – in which case the original founders get out with basically nothing, but the original sellers sign up for another tour of duty in hopes of making their original equity roll turn into something worthwhile. If you’re wondering why your colleague’s DSO “recapped” but he or she didn’t get any cash out of the recap, this is likely the reason why.
How This Ends
I don’t have a crystal ball, but I think any number of the following will happen:
- There will be a lot of PE-backed DSOs who either face balloon payments and/or some sort of covenant breach scenario(s) with their lender(s) and will be forced through a process between the equity holders, the operators and the lenders to recapitalize the balance sheet of the business in hopes that debt can be repaid in a reasonable amount of time, but the likelihood of any meaningful equity redemption is incredibly low. Call this the “Legal Work-Out Process” option.
- The Private Equity company that owns the DSO will do some simple math to determine that the value of the clinic-level assets is greater than the combined asset value of the business that is burdened by the corporate DSO overhead, so they will dissolve the DSO entity and sell off the practices (all together or some in groups) to other DSOs that have greater balance sheet integrity and sound operational constitution. Call this “the Consolidation of the Consolidators.”
- Private Equity groups don’t like to admit failure or have total write offs due to reputational risk in the investment banking world, so many will go to whatever ends necessary to financially reengineer businesses and funds to allow them to buy time. These businesses neither succeed nor fail, but just barely survive for an interminable amount of time. Call this “the Zombie DSO.”
- I don’t mean to paint the picture that every PE-backed DSO is poorly constituted or operationally unsound. There are a number that are very disciplined in the fundamentals of value creation: buying practices at reasonable valuations; recruiting and developing young associate clinicians for greater levels of productivity; managing cost structures and headcount to gain efficiencies through operations; focusing on marketing conversions for new patients flows; and creating greater an overall patient experience. These businesses are built for the long haul and will not only survive but thrive in the coming decade. Call this “the Return to Fundamentals.”
Silver Linings
Let’s not lose perspective on a few key points. One, dental practices are a wonderful blend of fixed and variable costs with low customer concentration and low service concertation. Couple that with high barriers to entry and unlimited demand for services, and these are incredibly compelling, resilient businesses to own. I’m not saying owning a dental practice is “easy” in any away, but the dynamics of the model are fantastic.
Two, everything I’ve shared in this essay conveys a “stall” in M&A activity at the top end of the market with a return to logical valuations and more rational expectations of would-be sellers. None of what I’ve shared will be solved by the end of 2026, so I would expect a good 5 to 8-year window of “Organic M&A Activity” in terms of doctor-to-doctor trades. If you’re a mid-career owner with a solid operational practice and a reasonable overall debt load, then you have a window of time to determine what kind of business you want to create – one that’s driven by cash flow considerations and not by ego.
Three, I believe in the “economies of scale” argument in almost every instance regardless of business sector. Dentistry is no different from banking or hotels or airlines or hardware stores. That being said, I don’t believe you have to have 100 locations to achieve it. Economies of scale can be found in revenue generation, operational efficiency, cost structure reduction and headcount synergy. If the ADA average general dentistry practice generates about $800,000 in revenue, then you can begin to realize some of each of those in the equivalent of 3 to 5 locations.
Time with No Constraints
Over the last decade, I’ve heard far too many people utter the familiar refrain of “growth and scale for exit over the next 5 to 7 years to work back for 3 or 4 and retire in 10.” Most never made it. Those who did gave up control of their most valuable asset and now work for someone else – or indirectly for the bank.
What if I gave you 20 years? 20 years to create a business that would offer a service that literally changed people’s lives for the better – and often forever? A business that you could work in providing that service a few days a week and then work in a leadership capacity a few other days a week? A business that would have other clinicians and business leaders to take some of the stress load off of your shoulders? A business that would create abundant cash flows for you and your family? And a business that would afford you the freedom of time to pursue endeavors of purpose?
Would you take it?
The best time to start that business was 20 years ago. The second-best time is now.
Go grind some beans.
PS – If you think this is something a friend or colleague should consider, please share it with them.
PPS – If you’d like to also hear a recent podcast I recorded on this subject, you can find it HERE.
