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The Secret of Why DSOs Hit a Debt-Funding Wall

Posted by Kevin Cumbus on Apr 12, 2018 6:00:00 AM

Life is good in your early-stage group dental practice.  dreamstimemaximum_31865366Revenue trajectory is positive, your growing management team is starting to click, and the culture across your locations is finally gelling.  With this growth, your profitability is down a bit as you have invested in your management team, but this isn’t a surprise – and you know it’s for the best in the long term.  It’s all starting to come together right in front of your eyes! 

Life is good – and it’s about to get even better…

Your Response to an Acquisition Opportunity

One day, a broker sends you a text with their newest listing: the location is phenomenal; the revenues are declining a bit; the cash flow is a little lower than it should be; and the price is a little higher than you would expect.  However, you immediately get excited because this practice is an ideal fit in your model.  You have the experience, the knowledge and the team to help you grow revenue and improve the cash flow.  You do some quick due diligence and decide that the price, while a little higher than you would like, is actually acceptable given the long-term opportunity. 

You are excited to move forward, so you put in a Letter of Intent (“LOI”), which is promptly accepted.  Everything is going great.  At this point you call your trusted banker and tell them about the opportunity.  They can tell how excited you are, and they match your excitement.  After listening to all the details, they wrap up the conversation by asking for the financials.  You love your banker’s excitement and are confident they will quickly deliver an approval. 

Your Bank’s Response to an Acquisition Opportunity

Over the next few days you send in all of the needed information and the bank starts their underwriting process.  After a few more days you start getting questions, like:

  • “Why are revenues down 2%?”
  • “Why are staff wages so high?”
  • “Why is the rent pretty high?”

Then they ask about your existing operations:

  • “Why are your wages up?”
  • “Why are your profits down?”

As you start hearing these questions, you’re shocked.  Why are they asking these questions?  Doesn’t the bank see the big picture?  Don’t they remember the conversation about building out your management team!? 

You pick up the phone and call your banker.  They start talking about your growth, but now their excitement is not where dreamstimemaximum_30142412it was only a few days ago.  You want to talk about your strong revenue gains, but they are concerned about your seeming lack of profitability (EBITDA).  You quickly explain that you added some staff for the back office, and a COO, all of these are positives to help with the future.  The banker agrees this is a good addition for long term growth, but with this decline in profitability, they need you to “press pause on expansion plans” until profitability rebounds.  They state that your “leverage is too high.”  Leverage?  This is not a conversation you were anticipating.  You experience a plethora of emotions, none of which help change the bank’s decision. 

How can the bank say no, when everything is going so well?     

You are not alone in this situation.

Almost every dental entrepreneur will feel this common pain at some point along their journey. 

This pain is what we refer to as “hitting the debt funding wall.”

“The wall” is a result of a memo issued by the Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve (Board) and Federal Deposit Insurance Corporation (FDIC) March 21 2013 Titled “Interagency Guidance on Leveraged Lending” (https://www.federalreserve.gov/supervisionreg/srletters/sr1303a1.pdf). 

The memo lays out guidance for banks to establish and follow leveraged lending guidelines.  Highly leveraged loans are considered high risk, and when done poorly can cause heightened risk across the financial system.  Here’s the important part:

These guidelines generally limit leverage for bank funded debt to 3x EBITDA.

This requirement is generally not a concern for banks when loan exposure is less than $1MM – which is roughly the zone around buying or starting a solo provider, single location practice.  However, as you continue to grow with total loan exposure approaching the $2MM mark, this guideline becomes very important.  There are plenty of loopholes, but once your outstanding senior debt balances near 3x EBITDA, you will have a much harder time obtaining bank funding.

Hitting the wall is inevitable in this industry.  The math is simple: practices sell for 3-8x EBITDA and the bank can typically only lend 3x EBITDA.  Upon closing even your first loan, your relationship is by definition “highly leveraged”.   If you aren’t quickly increasing EBITDA post acquisition and/or paying off debt, then the debt wall will become an obstacle you have to conquer. 

So, the question becomes: “how can you prolong bumping up against the debt wall?” 

dreamstimemaximum_78782930Here are three simple practices to help you out:

  • Do not utilized extended amortizations on new debt. Some banks will offer terms of 12 and 15 years.  If you are an entrepreneurial dentist who is looking to add on additional locations, these terms are not for you.  Stick to a max of 10-year terms to consistently reduce your principal balance.  If your cash flow can afford to go with a shorter term, this is even better.
  • Focus on execution with existing locations to maximize EBITDA. When growing through an acquisition strategy, it is critically important that you expand EBITDA immediately in order to create equity in your existing operations.  In an environment where market price puts you immediately into a highly leveraged lending category, it’s important to focus on growth to build equity.  Building equity in your existing business will help you to get past the debt wall when your next growth opportunity arises.
  • Be mindful of the price you are paying for new opportunities. Prices are high across the market, as there is increased competition for dental practices.  This is economics 101.  However, the price a privately-funded DSO can pay may not align with the price a group funded by bank debt can pay.  When shopping for practices, understand your situation, and build your acquisition plan around this.  Stick to your plan and avoid situations where you have negative equity for an extended period of time, as this will limit your ability to take on the next opportunity.

By following these practices, you will probably delay hitting the debt wall, but likely will not eliminate it forever. 

At TUSK we have over 30 years of combined experience in the dental lending space, and encounter these situations weekly.  If the story above sounds all too familiar and you want to discuss your situation in greater detail, please reach out to me directly via email at karnold@TUSK-partners.com.  TUSK provides industry-leading resources for Group Dental Practices and DSOs.  We help our clients START, GROW and SELL their Group Dental Practice or DSO.  For more details, visit our website HERE or feel free to download our Overview of Services.

Download Our Services HERE!

TUSK will be the featured presenter at the “DSO Foundations” seminar hosted by Patterson Dental Supply in Charlotte, NC on June 1&2, 2018 where we will present “Tactics to START, GROW and SELL your Group Practice or DSO.”   You can find more information and register HERE.  We hope to see you there as well!

To see where else we’ll be in the near future, please check our calendar for a listing of all seminars, conferences and presentations.   


Tags: Growing Your Dental Practice or DSO

TUSK Partners

TUSK provides Industry-Leading Resources to Group Dental Practices and DSOs, such as:

  • Full Day Deep Dive - Built to Sell
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