Equity arbitrage is a financial concept that was rarely utilized by dentists before private equity started investing in the space. In essence, it all has to do with how valuable the equity is in your practice currently and how much your equity ends up being worth after the sale of your dental practice. As with any asset, if a dentist owns their practice, they have a certain amount of equity. So, if you own a one-million-dollar dental practice and you’ve already paid off your note, you have $1 million worth of equity. Simple enough, right?
Here are all the ways equity arbitrage could play out during the transition of your dental practice.
When equity arbitrage takes place
Equity arbitrage occurs during a consolidation wave, just like we are experiencing in dentistry now. By owning your practice, you essentially own the cash flow that exists after all the expenses of the practice are paid, including a fair doctor’s salary to do the work. This cash flow works like an annuity, which you can leverage as an investment much differently than before consolidation. If your equity can be combined with multiple other practices’ equity, the large investment vehicle can grow faster and provide more returns.
Enter dental service organizations (DSOs), which can offer more money for the same practice because they’re private equity backed and, therefore, not beholden to the same debt ceilings that private owners have to deal with. The DSO compiles the equity of all the dental practices it’s acquired over time and sells them for much more on the open market. By banding practices together, a much higher financial result is accomplished, and the dentist can be a beneficiary of that arbitrage. The group of practices is worth more to private equity because there is much less provider risk; they can leverage their size for better deals with suppliers and there are more resources to deploy at problems.
For example, a single practice might be bought by a DSO for five to six times EBITDA (also known as earnings before interest, taxes, depreciation, and amortization), but that very same practice now part of the DSO is worth more than 12 times EBITDA. Just by switching the environment that the equity of your practice lives in, you’re able to garner two or three times as much, thus allowing the doctor to be a private equity investor in their own practice or in the group of practices that the DSO has banded together.
What is needed for equity arbitrage?
Dental practices are appealing to private equity (PE) investors because they have a steady cash flow and recurring clientele, and can be very profitable. During a consolidation wave, the plan is for the PE fund to buy a dental practice at a fair market value and increase the value of the equity that has been invested by five times over the course of a typical five-year PE investment cycle.
It may be appealing to wait until retirement before starting the sale of your dental practice, but you would be leaving a significant amount of value on the table.
Three different types of equity arbitrage
In a 100% buy, the private-equity-backed company now owns your dental practice from day one. Most of these groups allow dentists to reinvest funds in their organization, and, while some of them cap the amount that can be invested, those investments can work out very nicely for the dentists over time.
In a sub-DSO concept, either all or part of the practice is sold to the DSO and a new organization is formed underneath the DSO parent company. In this example, the dentist can hold equity in multiple practices that are supported by the DSO but not have the equity live at the holding company. Many entrepreneurial dentists like this concept.
With a joint venture, you could sell a 60% stake and keep 40% at the practice level so you can continue to receive profit distributions from your own practice and still enjoy the benefits of your equity being combined with other joint ventures. Many times, the percentage that you keep is worth more than your entire practice was on day one. However, because your equity still lives at the practice level, the investment in your own practice is still moderately riskier.
5 examples of equity arbitrage
Let’s say your dental practice is worth $2 million. You could:
- Sell a 50% stake to an individual for $750,000, then the other 50% stake for $820,000 as the practice grows over time, resulting in $1.57 million for a $2 million asset. If you bring on partners at 33% stakes for $500,000 transactions, you will probably end up with just over $2 million for your dental practice. That said, this plan takes a long time to execute.
- Sell 100% to a DSO for $2.2 million, which is more than an individual could have paid. You work for the DSO for a few years before giving them the keys, but you have no investment in the future of your dental practice. This is the way that most DSOs operated 10 years ago, and is good for a retiring dentist to consider.
- Sell for $2.2 million and roll $700,000 into your own equity platform, which grows five times over five years and turns into $3.5 million. You add the $1.5 million cash up front to the $3.5 million over five years, and you have an asset that was monetized at $5 million over five years.
- Go with a joint-venture model for $2.5 million, buying 60% of the dental practice at $1.5 million with the additional amount rolling forward. The 40% you kept is now worth more than the entire practice was before and because you’re still an owner in the practice, you still get distributions—so your practice ends up being worth $4.5 million.
- Consider a roll up with other like-minded dentists to get a much higher multiple than you could have accomplished on your own. You end up not having full say in the way that the group wants to transact, but it can lead to very positive financial outcomes for those who end up completing the transaction.
How do you start the equity arbitrage process?
Yes, DSOs approach dental practices all the time, but without the help of a broker, it’s hard to sort through all the multiples being tossed around to know how much you can actually make for the transition of your dental practice. The best way to know the true value of your dental practice is to have it appraised. Only then will you learn its enterprise value, which calculates the EBITDA profitability, along with how many multiples of this value groups will consider offering. A professional advisor will be able to assess your risk profile to determine how much you want up front versus how much potential you must earn with the sale of your dental practice.
There’s always risk in investments, and nothing is ever 100% guaranteed. As is often the case, the more risk you’re willing to take upfront could end up paying off in the long run. But there’s no one right way to sell a dental practice, so assemble your team of advisors before signing on the dotted line.
Editor's note: This article appeared in the September 2022 print edition of Dental Economics magazine. Dentists in North America are eligible for a complimentary print subscription. Sign up here.