Part 1: Blueprint for Long-Term Success
Keeping up with the rapidly evolving DSO landscape is a challenging task. There are over 150 private equity-backed DSOs and many more DSOs backed by other forms of private capital in the United States. In 2016, the dental space was less than 15 percent consolidated under DSO ownership and is now estimated at 25-35 percent. That is a jaw-dropping consolidation rate over a short time, considering the dental sector is the largest vertical of multi-site healthcare services in the US. There is a core of long-established DSOs and a rapidly growing field of newcomers entering this space. The models and strategies vary, and their outcomes will undoubtedly differ too.
Within the last eighteen months alone, over a dozen DSOs went to market, and approximately half were unsuccessful in finding an investor to recapitalize them. Additionally, a small handful of DSOs had substantial financial decline to the point their lenders ultimately took over ownership of those DSOs. This resulted in the investors having their equity value wiped out. These failed attempts are a stark reminder that not every group will have a successful financial outcome, despite the overwhelming confidence investors have recently exhibited in entering the dental market. From our perspective, this highlights the larger underlying issue within our industry: the DSO sector has not had enough time to establish a track record of expected financial outcomes. If the last twelve months are any leading indicator, then an optimal exit may be much harder to achieve than most anticipated. Despite a large cohort of DSO platforms with relatively short track records with private equity investments, dentists and investors alike are fixated on immediate financial gain. As this wave of consolidation behind a growing number of unproven platforms continues, we must ask, “What will come next? Is anyone thinking about what the DSO sector will look like in the next five, 10, or 15 years?”
Over the last several months, MB2’s leadership team has met with countless professionals within the US healthcare market and discovered that a universal question exists amongst sponsors looking to invest in the dental space and the bankers who fund those institutional deals: “What differentiates the DSOs that will thrive from the DSOs that will fail?” The other (and most important) stakeholder in the dental sector is the doctors themselves. We talk with thousands of doctors each year, and many of them ask us this same question, but this question is directed at us, and it is usually phrased as “What is the end game for MB2?” It’s as though the market intuitively knows that this recent wave of consolidation will not be good for all DSOs, and everyone is trying to determine what will define the winners and the losers over the coming years. Since we fully intend for MB2 to thrive, no matter the state of our industry or the capital markets, we have given serious consideration to this question.
Built to Last
After meeting with the most experienced professionals, financial intermediaries, and investors in the US healthcare market and reviewing countless variables and metrics, we believe there are several key attributes that DSOs must excel at to sustain long-term value for their doctors and shareholders.
- Alignment with the doctors. Most groups use doctor turnover metrics to quantify “alignment” with their doctors. To be truly sustainable, a multi-site group cannot simply function on a “sum of the parts” mentality. Eventually, the broader portfolio will crack if the individual parts cannot succeed on their own. The best way to achieve individual unit success is to ensure the doctors tasked with patient care continue to operate their practice with an owner mindset and benefit from their practice performance just as private practitioners do.
- Tenured leadership team. This is a people business. If long-term retention of doctors is priority #1, then long-term retention of the non-clinical leadership interacting with the doctors is priority #1a. The relationship capital established between corporate and clinical leadership sustains performance and maintains trust on both sides of a complicated partnership. Retention of tribal knowledge also reduces the propensity for repeated mistakes. This cannot be achieved if the corporate leadership turns over every few years.
- Ability to drive same-store earnings growth (organic growth). One of the hardest results to achieve in multi-site healthcare is growing the profitability of a mature business. Reimbursement pressures on the top line, and inflationary pressures on the bottom line make this an elusive outcome. If the DSOs of today cannot consistently drive organic growth, then the investors who are next in line to recapitalize these businesses will question the long-term viability of the DSO model. The dental world is overly infatuated with the consolidation craze, and investors have been fixated on buying low and selling high. A platform cannot create shareholder value on arbitrage alone. Many DSOs are only able to grow their earnings through M&A, which is an outcome that no investor will find attractive. To maintain a healthy balance sheet over time and create equity value beyond the simple arbitrage associated with multi-site M&A, DSOs must be able to drive earnings growth across their existing portfolios.
- Ability to execute an inorganic growth strategy. Successful DSOs must be able to execute on an M&A program to drive their financial returns; however, inorganic growth is both capital-intensive and risky. Too many failed acquisitions will strain a DSO’s operations and balance sheet. Selecting and acquiring dental practices that will add consistent value to a group requires experience, analytics, and discipline. Many newer DSOs have not yet seen the long-term results of their aggressive acquisition programs, and our recent market has had a bias for quantity over quality when it comes to growth. The decisions DSOs make today will have a crucial effect on their ability to achieve stable organic growth tomorrow.
- Ability to build multi-specialty networks. Access to care, provider availability, patient outcomes, and patient experiences are critical to driving new revenue growth. Groups can look to pricing (i.e., reimbursement rates), patient volume, or additional services to grow revenue, but these endeavors are a game of inches. The groups that build networks capable of integrating general dentists and specialists alike will create more long-term value for both patients and doctors and ultimately build a bigger moat around their business.
- Thorough and efficient integration capability. Multi-site healthcare is rife with companies that acquired multiple locations but did not successfully integrate them into their company. Integrating one company into another (regardless of size) is a tedious task that requires attention to detail across multiple business functions and a high degree of emotional intelligence in welcoming a business owner into a larger organization. If integration is not done properly, then the DSO and its acquired practice are distracted fixing business functions that were broken in the post-close confusion. Successful DSOs must efficiently integrate newly affiliated practices to ensure everyone’s attention can quickly pivot towards focusing on organic growth initiatives.
- Ability to deliver value to doctors. In an overly transactional marketplace, DSOs must create value for their doctors beyond just the cash in the initial deal. Leveraged pricing, payor negotiations, continuing education offerings, data analytics, access to new technologies, social perks, culture, and a community all contribute towards doctor engagement and retention. Without a high level of doctor engagement, any of the afore-listed capabilities will be very difficult to achieve.
- Avoid over-centralizing. Running a dental practice is complicated. Many daily functions that make a practice successful (staff development/front-end of the revenue cycle process, etc.) are best left at the practice. Some DSOs aspire to centralize certain functions to create value but quickly learn that sustaining those functions as they scale is impossible. Sustainable DSOs understand what functions they can best support their practices with and not overextend by trying to perform business functions that are better left at the practice. Someone must oversee and be accountable for these practice-level functions, though, which is why preserving the practice owner mindset is essential to having business success at both the DSO level and the practice level. Overpromising service offerings and service effectiveness to doctors and failing to deliver on those promises will only lead to long-term disillusionment with the doctors and employees who work at the practices.
The groups that can successfully deliver on these attributes will certainly stand the test of time as the DSO space matures. We are already beyond the early frontier days of mass consolidation within dentistry, and all stakeholders will inevitably adapt to the next phase in our industry’s progression. Things will not get easier for DSOs, and the sophistication needed to deliver value to doctors and investors alike will demand leadership, adaptability, and a compelling equity alignment model. Our next post will explore the equity models and growth strategies best suited for the future.