May 5, 2023
The Likely Buyers
Dental support organizations (DSOs) have become an extremely popular investment vehicle in the past two decades. The DSO business model continues to thrive and grow, in large part because of the vital support DSOs provide to dentists in managing their administrative, day-to-day business responsibilities. DSOs help dentists with the nonclinical business functions associated with running a dental practice, including accounting and billing, human resources, compliance, information technology, marketing and equipment and facilities maintenance. As the demands from the practice of dentistry grow, there is a steady move toward consolidation into larger organizations with better access to capital and efficiencies of scale.
While emerging DSOs may be backed by traditional lenders or private investors, the growth of larger DSOs is fueled specifically by private equity firms. Anecdotally, there are more than 100 (and probably closer to 200) private-equity-backed DSOs in the industry today. Most multilocation practices with scale and infrastructure have already been capitalized by private equity funds. Today, it is increasingly likely that the primary buyer for any asset will be one of these established DSO platforms, rather than private equity funds directly.
Many private equity funds see DSOs as a stable investment, as evidenced by the number of DSO deals closed in recent months. Private equity is particularly interested in the dental industry for several reasons:
As of this writing, the largest DSOs in the United States by number of administrative-supported practices are:
Self-Organization: The Alternative Approach
Instead of using a traditional private-equity-backed DSO, an alternative approach could include dentists attempting to self-organize enough independent practices into a single platform. This could be done before approaching the market and could allow additional flexibility for the dentists, since they would be able to retain more control if they do not sell their practice assets.
Despite the added freedom for the dentists, however, this approach can be fraught with challenges. Specifically, there is an increase in operational requirements for the dentists who serve the various practices, including managing human resources, employee benefits, IT, billing and collections, financial reporting and more. Incorporating the necessary infrastructure, professionalizing the management of the practices and achieving consistency across different practices and regions can be a daunting task. McGuireWoods does not often see this approach and would consider it high risk, high reward (potentially).
When Is the Right Time to Exit or Take a “Second Bite”?
When a DSO is established (usually with the backing of a private equity fund), there is almost always a view toward a secondary sale or recapitalization, which usually coincides with the fund’s investment horizon. A secondary sale provides liquidity for the fund and its limited partners and also provides an opportunity to continue to scale while synergizing best practices between the platforms. Generally, a fund will hold an investment for three to seven years.
Unlike a founder-owned business, deciding when to sell is not a straightforward question. It can be a complicated algorithm of equity market conditions, readiness of the company (and especially its providers) to sell, the interest rate environment, presence (or absence) of a natural suitor, age of the investment and any number of uncontrollable externalities. Timing is important, and it is critical to avoid misfires. A platform DSO that is preparing to approach the market will attempt to ensure that its “house is clean” from a regulatory and due diligence perspective. This involves a systems check of the core areas of focus — healthcare regulatory and compliance (including fraud and abuse and anti-kickback requirements), billing and coding audits, human resources, antitrust, real estate and IT/IP. Whereas financial diligence areas are typically in good order, oftentimes these other areas are not.
Several key dynamics are present in DSO (and physician practice management, or PPM) secondary sales that are not necessarily present in other types of transactions. First, during formation of the DSO platform and subsequent add-ons, providers typically take a reduction in overall compensation in order to generate saleable EBITDA. Part of the value proposition in partnering with a private equity fund is to increase profitability (through increasing revenues and decreasing operating and capital costs) in order to create “income repair.” In essence, this concept means that, over time, increased profitability will replace the compensation reduction incurred at formation. Depending on when a dentist joined the platform, this income repair may or may not have occurred yet (if at all).
Second, the sole engine of revenue for these types of businesses are the dentists and other clinical providers. They are the lifeblood of the platform and a critically important piece of the business going forward. This means alignment of clinical values is key. Enforceable noncompetes are also important (see, e.g., the discussion below on the latest FTC proposed rule on noncompetes). Clear clinical leadership, often in the form of a clinical governance board, is viewed very favorably. A culture of compliance is also highly valued.
Third, geographic diversity can play an important part in the strategy. Because corporate practice of dentistry restrictions and payor relationships vary so widely from state to state, often particularly difficult jurisdictions are balanced by less difficult ones.
What Is the “Second Bite” Like for Dentists?
A secondary liquidity event or recapitalization is often referred to as the “second bite.” This is when dentists experience a second (usually smaller) liquidity event with their rollover equity. Structurally, the secondary transaction could be a partial or full sale to a different private equity fund, a debt recapitalization or even an IPO. Some of the key characteristics are as follows.
Employment agreements typically are not renegotiated, but additional employment commitments sometimes are required — i.e., extending the term but not changing the compensation or other material terms. Any serious defects in the underlying employment agreements sometimes are revisited on a more targeted basis.
The secondary buyer may require providers to retain a certain percentage of rollover equity in an attempt to continue alignment of economic interests. This may not be enough to accomplish the stated objective — secondary buyers of mature platforms also look at strategies to economically align junior dentists who are promoted to “senior” or “partner” status. This often takes the form of profits interests, junior/subordinated equity, equity purchase programs and compensatory arrangements, all of which can be highly complicated and challenging to implement within the confines of healthcare regulatory requirements.
Dentists may be required to sign a broad, five-year noncompete (again) in connection with the purchase agreement. Although this type of transaction-specific noncompete is expected for platform-style deals, renewing these covenants for an additional five years (as a result of the secondary sale) can be challenging if dentists own only a very small amount of equity.
Indemnity provisions may be very difficult to craft because the selling fund will not want to have any residual liability (due to liquidity demand and lack of ability to claw back proceeds from LPs) and providers do not individually have the financial wherewithal to satisfy a large indemnity claim. A representations and warranties insurance policy sometimes can be used to bridge the gap; however, known liabilities still may need to be covered by a corresponding escrow. Ultimately, a higher level of due diligence (similar to a public-style transaction) may be required to satisfy the buyer that it is getting a clean company and satisfy the seller that there will be a limited universe of future potential liabilities.
Valuations and Recent Transactions
Recent Transactions. Notable recent transactions in the dental space that involved private equity firms include:
Among the various valuation methods, there has been a shift in the dental world to valuating based upon pro forma EBITDA rather than as a percentage of annual revenue. The value of practices has increased dramatically over the last decade. Large, highly profitable practices can now command a price of 4-7 times EBITDA or 100%-150% of revenue. The increase in value of dental practices is encouraging many practice owners to sell to DSOs rather than selling to private buyers. However, various factors still can impact a valuation, including financial performance, geographic competition, prospects for expansion, ability to add ancillary service lines, payor mix, compliance and more. Given the highly regulated nature of the healthcare industry, limited tools are available for evaluation, such as by offering certain compensation incentives post-closing.
Even as the dental consolidation market remains strong and purchase multiples continue to be high, the legal landscape is not without challenges that may affect DSOs and the strength of the dental market.
First, the Federal Trade Commission (FTC) issued a proposed rule on Jan. 5, 2023, that would effectively restrict an employer’s ability to impose a noncompetition restriction on its workers and, in certain circumstances, its owners/investors. If passed, the FTC’s rule would require existing noncompetition restrictions to be rescinded, and employers would have to notify workers that any existing noncompete clauses were no longer in effect and would not be enforced by the employer. The FTC’s comment period extended through March 20, 2023, and any new rule would be effective 180 days after the final rule is published. While the abolition of noncompetition provisions would have far-reaching reverberations for a variety of industries, healthcare and dental would be acutely affected.
Second, antitrust restrictions and obligations are becoming much more common in the dental space. State attorneys general have become much more involved in transactions that historically would not have required any state review or approval. For example, bills under consideration in New York and Illinois would create mandatory notification requirements for certain healthcare facility transactions at thresholds lower than the Hart-Scott-Rodino (HSR) Act. In New York, the proposed legislation would create a premerger notification obligation for transactions valued at more than $9.2 million if either party has assets or sales in excess of that amount. In Illinois, both the state House (H-2222) and Senate (S-1766) recently proposed legislation — that would be effective in January 2024, if passed — to create mandatory notification requirements for healthcare facility transactions. The legislation is intended to supplement the federal HSR Act by requiring notice to the Illinois attorney general of healthcare transactions that fall below HSR reporting thresholds, as well as requiring copies of HSR filings to be provided to the Illinois attorney general. Therefore, those dental transactions that may have required no prior state approvals will need to be reviewed by counsel to confirm whether any state attorney general review is necessary. Further, with respect to new private equity investors that replace those investors wishing to exit a current investment, such a transaction becomes even more likely to trigger state review.
Finally, economics are changing for those seller dentists, particularly those who will remain with the practice and receive equity in exchange for a contribution of assets. Currently, the purchase multiples in dental transactions remain high, despite a more tumultuous marked and increasing inflation. There could be a reset to the high multiples being offered for dental practices in the next several years. Further, particularly with respect to more established DSOs, the seller dentists will not be coming in during the early stages of DSO growth. The per-unit prices for rollover equity in established DSOs may be higher and the percentage ownership that any individual owner may hold will be lower. Thus, the economics may look less appealing for sellers. To the extent that a new private equity investor imposes significant rollover requirements upon sale or other obligations, an investment may be more restrictive than a small dentist investor intended when such dentist initially agreed to take rollover equity in a transaction.
Dental transactions and the DSO industry continue to be an appealing opportunity for investors, particularly as current private equity investors may reach investment horizons with their historic dental platforms. This “second bite” creates timing issues for the private equity investor and has further effects on the dentist investors that current and future private equity investors must balance. However, even with the challenges that may affect the dental industry and healthcare more generally, continued dental investment is expected to be strong.