A Changing Landscape: Dental Industry Continues to Evolve

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Dental providers are rapidly consolidating and giving rise to the emergence of Dental Service Organizations (DSOs). Choosing the right vehicle and capital partner will be paramount in order to remain competitive in such an environment.

Dental continues to be a beacon of growth, attracting an array of investors, entrepreneurs and capital providers. Consolidation, one of the industry’s most notable features in recent years, continues to gather pace resulting in increased M&A and private equity transactions. Given the availability of capital and opportunity to drive efficiencies and consolidation, such trends are expected to continue in dentistry. With only a small percentage of dental practices affiliated with a DSO, the industry is expected to continue seeing increased consolidation. Such an environment provides ample opportunities for growth however, careful consideration should be given to sourcing the right capital provider to finance growth initiatives.

Charting the Course for Future and Sustained Growth
Each DSO grows in a unique way. Nevertheless, everyone’s journey typically shares a common trait: working with a third-party capital provider, either to finance continued growth or for an equity event. For most DSOs that have already expanded beyond their first few locations, the most appropriate way to finance growth will either be through debt, typically issued through a commercial bank, or equity from a private equity (PE) firm.

Debt and equity financing provide fresh capital for growth. However, each has different potential implications for the company’s future. The decision about which instrument and provider is best suited for a business therefore requires careful evaluation and consideration to ensure it is the most appropriate fit to help an organization achieve its growth objectives. Cultural and strategic alignment between a company and its finance provider are also important. Regardless of whether debt or equity financing is being sought, companies should seek to engage with a thought partner that can bring value as well as capital.

Benefits of Debt Financing
Debt financing has traditionally been the choice for capitalizing businesses once the bootstrapping (founder/owner) capital is exhausted. However, debt can be useful in various stages of the growth cycle, either before, or in concert with, taking on a private equity partner.

Debt financing has a number of attractive characteristics for a scaling DSO, including:

The ability to retain complete ownership and control over operations without having to dilute voting interests.
Potential availability to smaller companies in earlier stages of the growth cycle which have not scaled to the point where they are a meaningful acquisition target.
Once a credit facility is repaid in full, there are no further obligations to the bank.
Generally, commercial banks have a lower cost of capital compared to private investors, so bank debt is one of the more cost-effective capital sources to finance growth.

DSOs considering debt financing should take into account a number of points of consideration, including:

Commercial credit underwriting requires a proven history of generating operating cash flow or EBITDA to support debt.
Loan agreements usually include financial covenants requiring the maintenance of certain cash flow levels or limitations on additional indebtedness.
Credit facilities have scheduled payments regardless of how well the company is performing. Bank financing may also require personal guarantees from the major shareholders.
Higher levels of financial reporting such as CPA-reviewed or audited financial statements may be required as part of the credit approval process and ongoing covenant requirements.
A company may need to evaluate additional investments in system infrastructure to ensure calculation of financial covenants satisfactory to the governing loan documents.

Private Equity (PE): Continued Interest in Dentistry
PE firms continue to have a strong interest in dentistry. They are attracted to well-run, professional companies with strong management teams. PE firms also look for strong cash dynamics coupled with sustained investment in infrastructure to help ensure scalability. Dentistry’s strong cash flow and track record of year-over-year revenue and EBITDA growth continue to drive consolidation.

Benefits of partnering with a private equity firm include:

Access to larger pools of capital, allowing a scaling company to execute a greater number of tuck-in/add-on acquisitions or go up-market on transaction sizes.
Depth of leadership and strategic insight. They can bring great expertise and leadership to the management team of a company.
Many PE firms have a demonstrated track record of structuring, scaling and optimizing companies either through execution of previous transactions or operational experience in the field.
PE investors can bring a roster of industry experts through professional service contacts and vendors that can help build infrastructure and realize efficiencies.
PE firms can bring great expertise and leadership to the management team of a company. In addition, some PE firms may employ a more passive investment strategy and allow the founding partners to continue running the company as envisioned.
PE firms can offer diversified financing sources through the issuance of subordinated or mezzanine debt as well as other credit facilities.
Generally, PE firms have an average investment horizon of five years, giving a PE-backed company a long-term strategic partner that aligns management and investor growth initiatives.

Similar to debt financing, points of consideration that should be taken into account with PE financing include:

Partnering with a PE investor will result in the dilution of management equity. Generally, PE firms take control positions in companies, which potentially give 50% or more equity to the PE firm. The control position may also require a majority of the board seats or voting rights.
PE firms often have a responsibility to their limited partners to hit certain performance targets and ultimately return capital upon maturity of their investment. This could potentially lead to differing views on how operations should be run on a day-to-day basis and which key metrics are most important to the success of the company.
PE firms typically structure transactions to align interests in order to best ensure success of a company as well as their investment. Such structural items may include earn-outs and continued employment commitments from the founders. Understanding a prospective PE partner’s investment strategy, management strategy and terms of continued employment is important in the due diligence process when taking on an equity partner.
Private equity transactions are generally structured as leveraged buy-outs (LBOs). The PE investor will typically invest a certain percentage of total enterprise value in equity, with the remainder funded through debt in an LBO transaction. While debt does help augment equity returns, it is important for the company to understand the optimal capital structure to ensure the balance sheet is not encumbered with too much debt. In addition, the company needs to ensure that the forward-looking projections are realistic and achievable so debt can be serviced with relative ease.

Charting a Course for Sustained Growth
Regardless of which source of capital a company decides to use, sustained growth and scalability without compromising quality of care should be the main priorities of a DSO.

It is therefore important for a management team to do thorough research on which bank or private equity firm best aligns with a company’s culture and strategy.

One of the most important factors to consider when selecting a capital provider is the stage of growth the company has reached and its future goals. Careful consideration should be given to choosing a funding source that understands a business’s history, objectives and broader industry dynamics. Interviewing a number of firms from both sides of the capital spectrum (see callout box for suggested questions) and asking trusted advisors for referrals will ensure the company not only gains access to required capital but also benefits from support and guidance during the next stage of its growth cycle.

Questions to ask when selecting a financing source:

For Debt

How well do they understand your industry?
Do they understand the nuances of a DSO structure?
Do they have the capacity to support growth?
Are they comfortable with lending based on enterprise value or do they require tangible collateral?
Are the proposed financial covenants attainable or too restrictive?
Can they make introductions to other industry professionals?
Do they have the capabilities to provide business-enhancement solutions?
Can they add value through thought leadership?

For Private Equity

What industry expertise do they have?
What connections does the firm have within your industry?
Can they provide strategic insight?
What is their track record of enhancing value?
What is their investment strategy and time horizon?
What structure will the PE firm employ (control, minority, debt, etc.)?
Are the growth objectives/milestones achievable?
Does a company have enough cash flow to potentially bring on a significant amount of debt?
What are the terms of the proposal (cash vs. deferred payout/earn-outs)?

About the Author:

Jamie Mantle
Vice President for the
Healthcare Specialty Group
Citi Commercial Bank
jamie.mantle@citi.com
(p) 713-752-5452

Read other Citi articles here:
Choosing the Right Capital: Financing the Growth of DSOs and Emerging Group Practices

© 2019 Citigroup Inc. Citibank, N.A. Member FDIC. Equal credit opportunity lender. Citi, Citi and Arc Design and other marks used herein are service marks of Citigroup Inc. or its affiliates, used and registered throughout the world. 1867759 07/19

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