Private Equity In Dental

With about $500 billion of uninvested capital, private equity firms are looking to invest in middle-market dental practices and dental businesses like yours.

In this article, Nick Barker of Huron Capital presents specific strategies for accelerating value creation with a private equity partner.

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As the owner of a dental practice, a dental products business, or a dental service business, you’ve surely heard about the overabundance of private equity firms looking to invest in middle-market companies like yours. With about $500 billion of uninvested private capital, competition among these firms can be fierce. With all this capital, along with a favorable debt market, company valuations are on the rise. With valuations rising, it is more challenging for private equity firms to achieve targeted returns for investors, sellers, and management teams. As a result, it is more important than ever for a private equity firm to develop and execute a detailed plan to create value that includes specific strategies for driving both revenue and profit growth. And it is especially important for business owners who are planning to reinvest or “roll” a portion of the proceeds from a sale of their company to be in lock-step agreement with the strategy and its execution.

This article will introduce three fundamental areas of value creation that go beyond a private equity firm’s initial equity investment. These three areas are as follows:

• operational
• financial
• strategic

This artilce will also discuss specific levers within each category that can be pulled to help accelerate earnings and create value for you, your management team, and your private equity partner.

Operational levers

An operationally focused investment approach is perhaps the most important tool of value creation. Operational levers can include:

• increasing clinic utilization by addressing daily treatment practices around scheduling, office process flow, and operatory setup
• improving purchasing scale efficiencies (primarily in dental supplies and lab supplies)
• adding additional clinic or manufacturing capacity
• building or improving upon customer service
• installing or updating IT systems that track and monitor operational and clinical key performance indicators (or “KPIs”)

Example: Huron Capital partnered with the management team of a short-term cosmetic orthodontic solution company marketed to general practitioner dentists. The orthodontic company’s lab technicians use a patient’s impression to create a mold, place brackets, and create a custom delivery tray, which together with product literature and other supplies are assembled and shipped to the dentist. Its lab and inventory management operations were originally housed in two separate locations in upstate New York. While the facilities were sufficient to meet the near-term needs of the business, they were not in an ideal location for recruiting talent (the facilities were located in a small town 30 minutes from the closest major city), and were not designed to house a dental lab operation. Furthermore, senior management was located in Texas, not at the production facility. With operational support and capital investment by Huron Capital, the company consolidated two locations in New York into a single facility in Texas, and moved from a highly inefficient physical layout to a building designed specifically for the company’s operations that expanded operating profit margins by approximately 90 basis points.

Financial levers

In an effort to enhance profitability through traditional routes like manufacturing efficiency improvements, it is not uncommon for a business owner to overlook the meaningful impact of financial levers. These may include:

• revenue cycle and working capital management
• alternative debt financing
• capital investment or divestment
• sales and leasebacks of real estate
• management of the fixed/variable cost structure

It may also include additional focus on recurring, nonproject-oriented revenue streams to reduce cyclicality or seasonality.

Example: Huron Capital partnered with the management team of a dental service organization formed to provide practice support services to a network of independent dental practices in Florida, Arizona, and Virginia. Revenue cycle (the time between when services are rendered and when final payment is received for services performed) is critical to the profitable operation of a dental practice. A shorter cycle means payment is received faster, which increases liquidity and reduces the likelihood of collection problems and write-offs. With Huron Capital’s strategic and capital support, the company invested in resources to focus on collections. It developed systems and processes to ensure accurate billing on the front end and more aggressive collection activities on the back end. These efforts resulted in an more than 30% decrease in the company’s revenue cycle, from 32 days to 22 days, freeing up cash and working capital for other revenue-generating investments (for example, expanded marketing and branding strategies to drive new patient volume).

Strategic levers

Strategic levers can be extremely powerful and transformative, yet are often overlooked entirely by business owners. This is certainly not surprising, as an owner’s plate tends to be full in managing the critical day-to-day operations, and additional resources are often unavailable to tackle vital strategic questions. Strategic levers may include:

• increasing patient volumes by adding clinical staff or additional operatories
• extending a company’s geographic footprint by affiliating with practices or acquiring businesses in other markets
• implementing new services (adding an endodontic program, for example)
• building a more sophisticated marketing strategy and business development process

Example: Huron Capital led the recapitalization of a dental service organization formed to provide practice support services to dental specialists in pediatric dentistry and orthodontics headquartered in the Midwest. Prior to Huron’s investment, the company existed in concept only and had no operations. With Huron’s involvement, the company developed a growth strategy focused on the highly fragmented pediatric dental market to build an affiliate base of dental practices in metropolitan areas, maximizing operational oversight and driving marketing efficiencies by clustering 5–10 affiliations within a 50-mile radius. In less than two years, the company has completed eight affiliations and now has 18 affiliated offices across five states. In addition to providing the capital necessary to affect these strategic affiliations, Huron also helped the company develop processes to grow the affiliation pipeline and enhance execution efficiency, develop a marketing plan for each office to drive new patient flow, and build out a call center to proactively manage lead generation.

Conclusion

As a business owner, choosing the right private equity partner is crucial to ensuring meaningful value creation, and you should feel challenged to select an investment partner with a common partnership philosophy who will bring more than just an “equity check” to the relationship. This is especially true if you are planning to reinvest a portion of your ownership from the sale of the company and share in the future upside. If the company, in collaboration with a private equity partner, management, and the board of directors, is successful at identifying and pulling one or more of the operational, financial, or strategic levers noted above, you could be poised to make significantly more than your original sale proceeds. Said another way, why settle for just 1 or 2 bites when you can enjoy the entire apple?

PE Dental Valuations

The Private Equity Investment Process: Case Study of a Dental Clinic Leveraged Buyout

Aimun Malik

Mar 13, 2019·10 min read

In this article, I seek to play the role of a private equity investor, highlighting the investment process, including initial market analysis, competitive mapping, and cost structure evaluation, as well as the creation of a three-statement financial model for the leveraged buyout of multiple dental clinics in a roll up transaction.

The purpose is to highlight some of the skills associated with the private equity industry and provide insight into how to evaluate potential investments. The hypothetical investment is the purchase, using leverage, of 5 dental clinics in Chesterfield, Missouri.

Dental Office

The Dental Clinic Roll Up

Dentistry has attracted a considerable amount of private equity capital, ranging from large transactions like KKR’s purchase of Heartland Dental, which supported more than 1,300 dentists across 35 states, to micro transactions of a small number of clinics within the same geography.

Private equity funds cite the large market, valued at over $73 billion, the opportunities for value creation in enhanced efficiencies, improved marketing, and investments in sophisticated technology that work at scale as reasons for investing in the space. These are just three of the benefits of a roll up strategy, with the others shown later in the following analysis; however, in order to formulate a data-driven opinion regarding the returns associated with a buyout of dental clinics, an investor must first come to understand the financials associated with one dental clinic- the unit economics.

The Financials of a Single Dentist’s Office

I am borrowing from Leonardo da Vinci’s wisdom when I preface this analysis with his quote “simplicity is the ultimate sophistication.” The purpose of this financial model is to be an illustrative tool with which to evaluate leveraged buyouts, roll-ups, and the purchase of dental clinics all at once.

The first skill set that is required to be an investor is the strategic skill set of building a total addressable market, analyzing the competitive landscape to get a perspective for market share, and building down to free cash flow by understanding drivers of cost structure.

The resulting analysis is below:

Dental Clinic Revenue Projection Model

Market Sizing

As every consultant knows, to begin this analysis we must get a perspective for revenue. I used Chesterfield, MO as an example for the analysis 1) because suburban relatively high-income neighborhoods with low rent make for attractive dental roll up candidates and 2) because that’s my hometown.

To get to revenue, the Total Addressable Market (TAM) was calculated using the population, the population growth rate, and the percentage of individuals who go to the dentist annually. In reality, people are instructed to go to the dentist twice a year, but for conservative estimates, the population was projected to only go once. Additionally, there were no Chesterfield specific statistics but using household income and percent of individuals who go to the dentist by household income, the resulting TAM was 32,781 annual patient visits.

Competitive Landscape

After market sizing, an analysis had to be conducted on the competitive landscape. For simplicity, it was assumed that each of the 15 clinics in Chesterfield captured an equal share of the patients, and two dentists per clinic was calculated based on required capacity to meet patient need while attending to 5 patients per day. Turning that patient count into revenue required an annual patient revenue number, which the American Dental Association cites at $653 per year. This results in gross billings of ~$1.47 million for each dentist’s office, of which 84% is collected (insurance companies discount billings to doctors) for first year revenue of ~$1.24 million.

Cost Structure

Dental Clinic Cost Structure Excluding Marketing Expense

Dental cost structure was fairly straightforward, with support staff projected as a function of dentists in a clinic and using average salary for a dental admin, a dental technician, and a dental hygienist. Growth in their salary was also projected at 2%. Fixed and variable costs were projected using data from Cain Watters’ annual dental performance benchmarking survey, save for marketing costs and rent expense.

Rent expense was projected based on required operating rooms per dentist and hygienist as well as projected square footage for the entire office per operating room. Additionally rent/square foot and rental growth were analyzed for Chesterfield and built into the projection.

Dental Clinic Marketing Analysis- Customer Lifetime Value and Customer Acquisition Cost

Marketing costs were calculated using a customer lifetime value vs. customer acquisition cost build. First, the churn rate was backed out from the average lifecycle of 8.5 years (primarily due to patients leaving the city), then the target new customers was projected as 25% above the churned customers for continued growth at an acquisition cost of $250/customer. This is a highly simplified example of one of the most important toolkits in a marketing executives set, which is analyzing CLV and CAC. Sophisticated marketers can segment the overall population and user base into various tranches and cater marketing strategies to the most valuable customers; however, the analysis presented here was highly simplified. Adept investors can switch into their marketing hats as easily as they can into their consultant hats.

Invested Capital

Dental Clinic Invested Capital

Finally, working capital primarily consisted of accounts payable and accounts receivable, which were benchmarked using industry average days payable and receivable, and capital expenditures were broken into maintenance and growth. Maintenance capital expenditures were equal to depreciation to maintain equipment and capital base, per 2.2% industry average. Growth capital expenditures were an initial ~$360,000 for updated equipment and integration costs.

Standalone Income Statement

Dental Clinic Income Statement

The resulting income statement combining the above assumptions shows that operating one dental clinic has 5.1% top-line growth, 76% gross margin, 19% EBITDA margin, and 9% net margin all expanding due to some degree of operating leverage and pricing power. This aggregation of data into a consolidated financial statement is a critical accounting skill set that investors must master to present cohesive analysis.

Private Equity Value Creation

After evaluating the market, the competition, and the financials of a target company, private equity investors must understand what the investment approach is that will be used to drive returns in the investment.

Each private equity fund has a different approach to creating value in the businesses they invest in. Some of the most common are:

1. Optimizing cost- looking for inefficiencies and optimizing the operations of the business to increase EBITDA
2. Targeting growth- investing in new products, channels, customers, or simply taking advantage of organic tailwinds in the company’s industry
3. Utilizing leverage- using residual cash flow to pay down debt and increase value through owning more of the business
4. Investing in Distress- Investing at low multiples in distressed or struggling companies and then stabilizing them to sell at higher multiples
5. Implementing Acquisitions- Implementing M&A, achieving scale benefits, reducing competition, or bolting on synergistic assets

Typically, private equity firms will utilize a combination of the above investment approaches and, after analyzing which approaches are utilized, a more granular look is taken to identify the key actionable areas to generate value. This skill set of identifying areas of improvement in a business and implementing those changes can be categorized as an operator skill set.

In the case of the dental clinic roll up, there are 6 primary value levers that can be pulled:

1. Pricing power- patients are willing to pay more due to stronger brand, better offering, and lower competition
2. Increased collection rates- larger dental clinics have negotiating leverage with insurance providers and better software for collections
3. Lower customer acquisition costs- lower CAC results from software (customer relationship management software), brand investment, and larger footprint within a relevant geography
4. Lower lab fees- since dental clinic is more strategically valuable to the labs, the clinic can receive bulk purchasing discounts for larger patient base
5. Lower rent growth- the increased size renders operations more strategically valuable to land owners and provides negotiating leverage in expanding and moving into lower cost clinic locations
6. More attractive cash conversion cycle- larger firms have more negotiating leverage over suppliers and can extend payables while collecting from insurance companies faster

These advantages are projected to increase as more clinics are rolled up per the below:

Value Creation Levers based on Clinic Count

The Leveraged Buyout & Roll Up

Leveraged Buyout Structuring

The structuring of the transaction, including building the financial model, raising and servicing debt financing, and projecting returns comes from the valuation and transaction skill set.

When building the transaction model for the 5 clinics, a number of terms were utilized:

1. 110% purchase price as % of revenue (referred to as collections)- a premium to the 70% — 85% collections range average
2. Entrance into a revolver with L + 3.5% rate left undrawn (in advance of initial capital expenditure)
3. 3x leverage with a term loan at L + 5.0% given strong margins and growth story in the business
4. 4% transaction fees (higher than average because of multiple transactions for roll up and financing fees combined for simplicity)
5. 10% management option pool from sponsor equity for incentive alignment

It should be noted that the capital expenditures scaled with the clinics rolled up because of the initial requirement to consolidate operations, integrate the businesses, and invest in new equipment across all clinics. The additional growth capital expenditure in 2020 was utilized to invest in the software required to increase collections, increase cash conversion cycle, and lower customer acquisition costs (for example, Customer Relationship Management software).

Below are the three statements and the debt sweep from this transaction

Dental Clinic Roll Up Income Statement

Dental Clinic Roll Up Balance Sheet

Dental Clinic Cash Flow Statement

Dental Clinic Debt Sweep & Credit Statistics

Returns

Leveraged Buyout Returns from 2019–2029

Assuming a very conservative 4.0x exit multiple vs. 4.87x purchase multiple and compared to an industry average of 5.0–6.0x multiple for multiple doctor, multiple location practices, 5 year returns yield a 4.4x multiple of invested capital (MOIC) and a 34.6% IRR. From a private equity investor perspective, this is a very attractive investment and warrants the amount of capital that has flooded the industry.

Takeaways

In an effective dental clinic roll up, the private equity sponsor purchases multiple individual practices, often at less than 1.0x revenue (characterized in the industry as a percentage of collections) and invests a considerable amount of capital into combining the organization, enhancing the software product suite, and improving the equipment used across clinics. The benefit of the increased size of the entity as well as the capital injection comes by way of pricing power, more effective collections, lower customer acquisition costs, lower COGS, lower rent expense, and more float resulting from a more attractive cash conversion cycle.

Crucially, these attractive returns stem from scale benefits, and as more clinics are combined under one organization within a given geography, the benefits of scale in terms of branding and negotiating power over suppliers accrue to the private equity sponsor. When evaluating the leveraged buyout of just one dental facility, the 18.2% IRR doesn’t present a particularly compelling investment given the risk profile and illiquidity associated with transactions like these. As more clinics are added to the fold, however, the resulting IRR values climb to the point that by 5 clinics, they are attractive across the majority of the sensitivity spectrum, particularly on lower purchase prices.

Taking a step back, private equity investing involves a number of complex skillsets.

First, in order to be a strong investor, a sponsor must be able to accurately project what revenue will look like, having a strong understanding of the industry, the risk profile (not covered but critical for diligence), and the idiosyncratic characteristics of the industry. This skill set is well aligned to the skills developed in a consulting role.

Second, given the emphasis on growth through new customers in this transaction, the investor needed to understand customer lifetime value and acquisition costs, as well as the more effective tactics to attract and retain new customers, which in more detailed scenarios includes cohort analysis, segmentation, and statistics. This is a skill set developed in the role of a marketing executive.

Third, investors must have a firm understanding of accounting and how to aggregate data into financial statements to understand performance and liquidity as well as to be able to present this information to stapled finance providers and investors. This is a skill set associated with Certified Public Accountants.

Fourth, investors must be able to identify areas for value creation- initiatives that can improve the quality of the business- and implement the changes necessary to capture that value. In our case, investing in new equipment and software were some of the major value drivers. This is an operator skill set, developed by high level executives.

Finally, an investor requires a technical and valuation skill set to put these pieces together and see the resulting return profile in a leveraged buyout transaction. This transaction skill set is similar to that of investment banking.

In short, this exercise was designed to illustrate at a very high level how a private equity investor evaluates a transaction and what skills are required to do so effectively.