Selling up for millions: Equity arbitrage increasing wealth of US dentists, but not for long

Mr Francis, let’s start from the beginning. Could you explain what the term equity arbitrage means?
Equity arbitrage is not a new concept; it is all about where your equity lives. Traditionally, dentists have owned their practices, and this situation has been very similar to that of other family-owned shops, such as bakeries and hardware stores. Where does these business owners’ equity live as the business grows? In the family-owned model, the equity is going to be in the asset that they have created, and it grows over the course of time just like the value of a house. What happens during an equity arbitrage event is that, as an industry begins to be consolidated, practices are joined together by different financial instruments, and the type of equity can move from the practice level to the holding company level—in dentistry, that means to the dental support organisations (DSOs).

The DSO is essentially the financial instrument that ties those practices together, and it just so happens that the practices then become substantially more valuable.

What causes this increase in value?
Let us take the example of a corner sandwich shop that is a small-scale family-owned business and has a certain amount of value. In comparison, each Subway sandwich location is worth way more, and that is simply because the likelihood of the revenue continuing is much higher. Whereas the expected revenue is higher, the risk becomes much lower because now you don’t have to worry that the owner may be injured in a mountain bike accident, which can have an impact on how the shop—or dental practice—operates. Basically, as soon as you get scale in numbers, that translates to higher value overall within that DSO. Then, if you end up transferring where that equity lives, it can be worth significantly more, even the very next day after selling.

So it is really about the backers, the people or the brand name behind the lease?
Yes, almost all DSOs or groups are backed by private equity funds. There are thousands of private equity funds in the world, and quite a few of them are interested in investing in dentistry. Historically, dental practices have been undervalued. Now that private equity is shifting its attention towards the industry because dental practices are very attractive investments, the value of practices has increased dramatically as a result of the growing competition between private equity groups.

What role is consolidation playing in this?
Right now, the dental industry in the US is about 30% consolidated, and we are heading towards 60% to 70% consolidation in the next seven to ten years. This has been happening for the last ten years, and we think that we are currently about halfway through this consolidation wave. So, there is still a lot of runway left for these types of assets to be available.

On what do you base the prediction of 60% to 70% consolidation?
Part of it is based on the consideration of comparable industries. If we look, for example, at cosmetic surgery, dermatology or optometry, these industries have ended up heading to that same place. There are also other comparable industries, outside of medicine, which show us that, as an industry consolidates, there will still always be small-scale businesses out there. And it is the same thing in dentistry. Some clinics will remain independent, but many others will join together.

How does equity arbitrage have an impact on the consolidation process and on practice owners when they decide to sell?
I think that the easiest way to talk about this is to provide some historical background. Private equity began to invest in dentistry around ten years ago, and at this time the only recipients of the equity arbitrage were the private equity funds. They would buy a dental practice typically paying more than an individual would, so the owner-dentist could sell a million-dollar practice for a couple of hundred thousand dollars more. He or she would be pleased about having secured a great deal, right?

However, once the DSO compiles those practices—let us say that it puts 100 practices together—they are suddenly worth something like two to three times more than that original purchase value. In that way, the only recipients of that arbitrage were the private equity funds—or maybe the founder of that original clinic.

What is interesting is that, as the competition picks up during the consolidation wave, there are going to be more opportunities for dentists to become private equity investors in their own practices. Currently, there are at least 350 DSOs out there, and the chances of dentists finding a situation that allows them to share in the equity arbitrage is much higher.

Let us say that the dentist still owns that million-dollar practice. Instead of it being worth US$800,000 to an individual, or US$1.2 million to a group, what he or she could do is take that US$800,000 off the table as cash and roll the remaining US$400,000, which was the difference, into a holding company investment. That could end up growing at about 80% per year, which means a growth rate of almost five times over a five-year period. You take that US$400,000 and multiply it by five, and you then have a piece of the pie worth US$2 million, even when your practice only had an original value of US$800,000.

The period of investment in a holding company is important, but will these market dynamics change in the mid-term?
The longer that you are in an equity arbitrage environment, the more dramatic the results. If it continues to grow at 80% per year—and historically, it has—then suddenly, over the course of ten years, you can talk about a difference of ten to 15 times the original value. The growth becomes more and more dramatic the longer that you are in there, but we only have a certain amount of time left. As I mentioned, we only have about seven to ten years left, so I would say that dentists who become involved in this now could gain five or six times the original value, and that is roughly what I would expect.

“Ten years ago, this option was not there for dentists who were selling, and this will not be an option for those selling ten years from now”

Do you consider this as an important motivating factor for selling to a DSO?
Very much so. Consolidation only happens once. Once the process reaches an end of sorts, that equity arbitrage goes away. It is still valuable to hold the stock of those larger corporations—in the same way that it is valuable to hold Apple stock, which still grows and provides returns to investors. DSOs will end up being dividend-paying stocks in the long run, but currently it is a high-growth stock to hold.

Ten years ago, this option was not there for dentists who were selling, and this will not be an option for those selling ten years from now.

Do many dental practice owners know about these market dynamics?
In the last year, I have done around 400 to 500 prospectus reviews, which basically involve analysing a practice and telling the practice owner about his or her own asset. I would say that of those practice owners, only around ten of them knew about and understood the concept, around 50 of them had heard of it, and the vast majority of owners had never heard of the concept.

Can you provide an example of how equity arbitrage has played a role in the recent sale of a single practice?
We worked with a practice in Texas. It had a total revenue of just under US$4 million, and three partners were involved. The older partner came to us and said that he wanted to sell his third of the practice. In such a case, normally the only option is to find an individual who is willing to purchase that stake. This was a valuable practice and, according to our appraisal, we thought that we could achieve around US$1.4 million for his portion of it. However, when we started talking about consolidation and what is happening on the US dental market, all three partners decided that this was a good opportunity to consider their options. We ended up having about 60 inquiries about the practice and around nine offers. Eventually, the partners chose a deal for US$13.4 million, meaning that each third of the practice was worth more than US$4 million. Essentially, all we did was change who the buyer was. The senior dentist ended up using the services of the DSO to recruit and hire a person to take his place, the staff continued to work there, and everyone got paid up front. On top of that, they retained ownership of 30% of their practice.

They are about to transact with private equity right now, and the implicit value that we think that they are going to get—just for that 30%—is another US$10 million.

Essentially, what we did was take an asset that was worth US$4.2 million and we increased it over the course of four years to be worth between US$23 million and US$24 million, just by allowing the dentists to be investors in their own practice and to take advantage of equity arbitrage.

This is not a unicorn example. It is a relatively normal sale event that takes place all the time.

Thank you for this interview.

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