Capital Markets, DSOs, and Dental Practice Valuations
The dental sector has been consolidating at an increasingly faster rate. As the uncertainty that accompanied the COVID-19 pandemic began to subside in late 2020, supernormally low interest rates, easy access to capital, and pent-up investor demand fueled a buying binge by both newly established and long-standing DSOs. The capital environment, coupled with investors’ enthusiasm for the dental space, drove valuations for dental practices to unprecedented highs.
The initial surge of EBITDA multiples adhered to some semblance of market fundamentals. Dental practices with substantial EBITDA ($1mm+), high-growth potential, and low long-term execution risk all commanded premium multiples. What ensued in 2022 was a massive level of transaction activity that lacked even a modicum of sustainable investment rationale. Dental practices with size, keyman, payor, and geographic risks that would have been valued at 4.0x – 5.0x EBITDA from 2018-2020 traded at multiples comparable to their larger, more successful peers.
Based on the 5,000+ transactions we reviewed in 2021 and 2022, the spread of multiples between high-quality investible assets and higher-risk assets with less upside shrank dramatically. Dentists decided to sell their practice based on FOMO and the expectation of life-changing money in a future private equity-funded recapitalization. Institutional investors funded start-up DSOs to ride the tailwinds of the arbitrage opportunity in the dental marketplace. They put capital to work while debt capital was priced at historic lows.
Many of the former overestimated the magnitude of wealth they would earn as a member of their DSO. Many of the latter did not appreciate the difficulty in sustaining a dental business, nor did they account for a market correction or a shrinking arbitrage opportunity. In the third quarter of 2022, the commercial debt markets seized up, and private equity investors very suddenly had to tighten their investment review standards in the face of macroeconomic risk and a higher cost of capital. We are just now seeing the downstream impact on the DSO and dental practice transaction market.
Current State of Affairs
As DSOs – large and small, new and established alike – begin to digest their newly acquired business, the challenge of operating and growing a portfolio of multiple dental practices will demand both infrastructure and capital. This challenge only compounds with time. We can tell you from first-hand experience that acquiring dental practices is one thing, but successfully integrating and supporting those practices while continuing to add new ones requires strong leadership, a lot of infrastructure, and the willingness (and ability) to invest capital to support organic growth. Doing these things successfully is critical to raising new capital (both debt and equity) to fund future acquisition growth and creating long-term value. The groups who overvalue practices, overestimate practices’ earnings at the time of acquisition, or experience a decline in post-acquisition performance will not be able to raise new capital to fund acquisitions once their capital runs out. Many groups will be forced to pull back from an aggressive acquisition strategy due to the need to focus on operating their existing business, or lack of capital, or both. DSOs that have continued to both acquire new practices and operate their existing portfolios successfully will look to moderate multiples in the face of a higher interest rate and debt-constrained capital environment, as well as to not put their balance sheets at risk.
Another dynamic that many did not see coming is a cooling of investor confidence in DSOs. Private equity investors must weigh the risk and return decisions against their increasing cost of capital. Over the last six months, investment committees have become increasingly wary of investing in DSOs. Unproven track records, inability to grow the baseline business, concerns over doctor turnover, and the lack of a cohesive strategy are all reasons that have been cited in the case against DSOs. Businesses built on the idea of amassing a bunch of dental practices and selling the larger enterprise at a higher valuation (i.e., arbitrage) are simply not that attractive to sophisticated investors. There is now a flight to quality in which private equity sponsors will carefully elect to invest in DSOs that can maintain long-term alignment with the doctors, drive consistent same-store earnings growth, create meaningful equity value beyond just the arbitrage between buying and selling, and have committed leadership teams.
Very few DSOs can deliver on all these variables. A multitude of DSOs have gone to market over the last year and could not find a new investor willing to recapitalize (i.e. invest in) their business. This trend alone will contribute to some downward pressure on multiples for dental practices, as PE-backed DSOs must have confidence that they can successfully exit after deploying large amounts of capital.
One of the biggest factors that will alter investors’ valuation standards is the change in the debt markets. We are all aware of increasing interest rates because that data point is easily translatable to everyday consumers making decisions around buying a house or a car.
In addition to a rising rate environment, lenders have also pulled back on the leverage they will extend to PE-backed companies executing leveraged buyout transactions. Prior to 2022, it was not uncommon for a PE-backed platform to have access to debt capacity up to 6.5x EBITDA. That capacity has contracted back to ~5.0x – 5.x EBITDA. In this environment, DSOs must contemplate their current covenants, the future debt capital they will need access to for purposes of continued growth, and the debt capital that will be available to support their own recapitalizations. This pressure will likely steer DSOs to become more selective about the acquisitions they make and also force them to moderate acquisition multiples from the historically high multiples we have seen over the last two years. Very few companies have enough free cash flow (cash available after funding operations and debt service) to wholly fund new acquisitions. Nearly every DSO (that we’re aware of) requires outside capital (debt or equity) to fund new growth.
What Goes Up, Must Come Down
The sky is not falling, and we are not suggesting that a collapse within the DSO space is near.
We are, however, seeing early signs of some compression of EBITDA multiples, which is a logical outcome from the resetting of market conditions that existed in 2021-2022. We have talked to multiple investment banks, commercial banks, and private equity groups who have all said, “the current math just does not work.” There are more groups than there ever has been in the market, so we believe the DSO market will bifurcate into “aggregators” and “real platforms”.
Aggregators seek to amass individual dental practices as quickly as possible and create value for their shareholders based solely on arbitrage (the spread in multiples between buying and selling).
Investors are dubious of the long-term sustainability of this approach and the lack of infrastructure needed to create equity value in other ways. A real platform is a group built to stand the test of time. Platforms have cohesive strategies and follow a disciplined investment approach to maintain a healthy balance sheet and create repeatable and sustainable equity value for their shareholders. Both of these buyer types will influence valuations within the dental market, but the premier platforms will be the ones who will survive long-term, regardless of the state of the economy or dental marketplace. It will be up to practice owners to decide which DSO gives them the best financial opportunity and additional support that they want out of a practice sale.
If you’re a dentist and believe that selling your practice may be a good move, do not let this post dissuade you from exploring your options. The market conditions and current dental space dynamics are not likely to change anytime soon. It may be years (or never) before we see a capital market like we saw in 2021-2022. As the dental industry becomes more consolidated, the many varied DSOs will have to prove their strength to their doctors and value to investors over a longer time period. If talk of high valuations is the only thing causing you to think about selling your practice, then we encourage you to think deeper about your long-term goals (both financially and operationally) for yourself, your practice, and your team. Any savvy investor will tell you that “timing the market” is not a sound way to make a transaction decision. Since we believe this current landscape is here to stay for a while, dentists should focus on selecting a DSO that will provide them with the best long-term financial outcome, not the initial valuation they can achieve on their practice. There is still substantial upside for dentists to create meaningful wealth for themselves, but only if they select a group that can deliver on continued financial success.