Doing business, interacting and dealing with Private Equity (PE) firms can be a scary and daunting process for any business person let alone dentists who are not used to the complex terms, contracts, ratios, metrics and language PE firms use. With almost 30 years’ experience in the DSO business and having raised over $700 Million, I have seen failure and experienced success. Entrepreneurial dentists commonly run into two roadblocks. One is the capital to grow and the other, not so obvious until it becomes crucial, is management infrastructure. To be successful in the dental business requires the successful collaboration of doctors, management team, infrastructure, and capital.
Unless a dental group is able to self-fund, in order to grow in the DSO space, an investor with significant capital is required. I started in this business at the end of an era, where my first dental acquisition came through a handshake with a bank loan officer. There was no loan application, minimal paperwork and I received a loan which was 125% of the purchase price. As my dental group grew and the economy changed, I could no longer rely on bank financing. The capital raises evolved, beginning with family, friends, bank debt, then mezzanine debt and eventually private equity from institutional investors and even a billionaire.
It is important to note that not all private equity firms are created equal. Doing business with a private equity firm is a marriage and if you pick the wrong one the relationship will become contentious and nine times out of ten, the break-up is going to come with nasty legal expenses. It is therefore important to understand how to enter into a relationship with a PE firm and its principals.
To do that, let’s begin with some basics. In my experience, there are different classes of PE which are all based on the amount of dental group/DSO EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) they target to buy or invest in. Most won’t be interested unless the company has a threshold of $5.0 Million in EBITDA regardless of revenue (I will discuss revenue, multiples of EBITDA and valuations in the future). This is mostly due to the PE firm internal charters and how they raise capital from various pension funds, insurance companies, endowment funds and different entities with cash to invest. The next level is between $5.0-10.0 Million. This pool of PE firms is smaller but still fairly large. The level after that is $10.0 – 15.0 Million. The next level is $15.0M+. When it comes to companies with $100M+ in EBITDA then PE firms and large funds typically come together and syndicate their deals.
In general, a PE firm main interest, oversight and management in the dental group/DSO will depend on several factors including the experience of the Founder/s, the EBITDA, the track record, and the consistency and stability of the cashflow. From these factors emanates the PE philosophy which may include investing in “distressed” companies, “value-add” companies, “buy and build,” “management growth”, “partnership” and the highest level “investment grade” companies. Understanding this philosophy is important as to whether or not the founders and management team stays on post investment. (This is another topic of discussion for the future).
While private equity will look to the dentists and management team’s experience and track record in the business, you should also look at the PE firm’s experience and track record as well. PE firms raise capital from various sources, as described earlier, called Limited Partners. The PE firm, as the General Partner, may invest their own capital which may include as well the Principals/Founders/Directors/Managers of the PE firm. Generally, there is a limit to the capital raise in a Fund as well as having guidelines on what they will/can invest in. The lifespan of these Funds is anywhere from 3 to 12 years depending on how well they deploy the capital, the performance of the portfolio companies and the sale/disposition of the assets in the Fund. The Fund will have performance metrics applied to it. The success or failure of each Fund determines the reputation, viability and longevity of the PE firm. Having multiple open and/or closed Funds should give clues as to how good the PE firm is. To this end, I would take it one step further in understanding the industry sector focus of the PE firm; unless the PE firm has healthcare investing experience or invests in a service sector company, understand you will need to educate them on the dental business which is mostly elective versus a typical physician’s practice. The dental business is about service, and as such the philosophy, approach and PE management oversight to help make business decisions is very different for investors than those focused on manufacturing, real estate, technology and finance sectors.
While it is important to understand PE experience and the sectors they have invested in, it also vital to be philosophically aligned on how to grow the business and to the commitment of capital to improve the business. If dentists and management feel adding or upgrading equipment, facilities and technology will increase quality, patient satisfaction, and revenue then having an understanding on the requirements on how the PE firm will make the capital investment is an important term between all parties. Sometimes a PE firm will feel you need to prove performance before they invest which can be almost impossible at times.
All doctors fret about control so let me say that most private equity firms will want majority ownership and control of the asset (the dental group) to make decisions on expansion, acquisitions, funding additional capital or debt, sale or disposition of the asset and changing management if things don’t go according to plan. The truth of the matter is that they will not come to your office to practice dentistry. They will not build relationships with patients nor the teams in the offices. They do not make clinical decisions nor interfere in the practice of dentistry in spite what some may want you to believe. Most PE firms will want the dentists focused on providing quality dental care and to find ways to raise the standards of care, while improving quality and producing happy satisfied patients. In the end, the doctors have full control of the practice and the performance. The issue is when performance begins to drop and expectations change. That is where problems start to occur.
Another matter to understand is how profits are shared once all the capital invested is fully returned. Most PE firms require the portfolio company to pay “preferred interest” which is what the PE firms give to the Limited Partners or anyone who invested cash into the business. Some may add an arbitrage for themselves. There will be various and complex arrangements for sharing profits. It is really important to understand if there are management fees the PE firm will impose on the business and what fund expense allocations they plan on charging the dental company partnership. This all can be non-starter as the pie left to share after the “preferred interest,” PE firm management fees, the fund expense allocations, etc., may be a lot smaller.
An important component to having a great relationship with a PE firm is to understand the oversight and reporting which the management team will most likely be accountable for. If expectations and or actual performance is failing all bets are off and the PE firms will begin to micro-manage, restrict decision making and tend to over-analyze on matters that have no relevance or impact to the operations and financials of the business. The relationship/partnership can spiral out of control. The PE firms will have at their disposal a range of simple to drastic measures to right the company which is also not the focus of this article.
Last, I think it is important to know who the principals in the PE firm are. Life is too short to do business with people you dislike, disbelieve or mistrust. What is their experience and what kind of leaders are they? The quality of the person you are dealing with makes the biggest difference. Do you feel they are honest, direct, truthful and trustworthy from the time you meet, through the wining and dining you will most likely share, to the due diligence they will do on you and the experience of the process? You must trust your instincts to know if the people in the firm are straight or slimy.
In summary, choosing a PE firm is akin to a marriage and it is vital to be diligent in understanding their expectations, philosophy, as well as reviewing the history of the fund/s, the firm experience, and the Principals’ knowledge. Equally important is their leadership style, the management oversight, reporting, their fees and the profit sharing methods. This can be a very rewarding experience when everything comes together in a partnership where all parties win. The right partnership is absolutely worth embracing. The best advice is to be smart and prudent as you travel through the process of choosing a PE firm as a business partner.