Written by Brian Colao, Director, Dykema Dental Service Organizations Industry Group.
On March 5, 2020, I wrote the below article concerning the impact of a potential recession on the DSO industry and the dental M&A markets. At that time, we were on the 11th year of an incredible period of economic prosperity and the consolidation of group and solo practices into DSO affiliated practices was occurring at an unprecedented rate. Of course, I had no idea that less than 2 weeks later the world would be in the midst of a once-in-a-generation global pandemic. Since that time the dental industry has endured the great lockdown, the great reopening, the great recovery, the great resignation and now the great inflation.
Although over two years have passed since the article was published, in the current economic climate, the original question still remains: Are we headed for a Recession and what impact will it have on the great evolution and consolidation of the dental industry. Therefore, I have updated my original article set forth below (which could easily be written almost word for word today) with current and up-to-date commentary bolded below.
Up until very recently, we were in the midst of one of the longest periods of economic expansion and growth in history. The recent bull market, which began in March of 2009, was going on for 11 years in duration and officially the longest bull market in history.
During the Great Recession of 2007, the dental industry demonstrated that it was virtually recession-proof and continued to thrive while other industries hovered on the brink of collapse. As a result, the end of the Great Recession of 2007 sparked enormous and unprecedented interest in the dental industry from non-dentist investors. This has led to the Great Evolution and Great Consolidation of dentistry, where dentist-owned solo practices and group practices are monetizing the value of their practices by affiliating with DSOs at a record pace.
This explosive M&A environment has created once-in-a-generation returns for sellers with EBITDA multiples for large DSOs and group practices routinely hitting the double digits, with some even exceeding 18X. To date, DSO market penetration sits at just under 25 percent, which leaves an enormous runway of potential continued expansion over the next 10 years.
However, based on historical data, it is virtually inevitable that another recession will occur sometime in the not–too-distant future and many in the DSO industry are wondering what effect a recession might have on the Great Evolution and Consolidation of the industry.
UPDATED COMMENTARY: The cost of labor has significantly gone up due to the labor shortages caused by the pandemic and inflation is at a 30 year high due to a variety of economic conditions such as overactive stimulus packages, the war in Ukraine and different economic policies advanced by a new presidential administration. Many commentators believe we are either already in a recession or will be in one very shortly and some tough times may be ahead for certain sectors of the economy.
What is a Recession?
A recession occurs when there are two or more consecutive quarters of negative economic growth. Business sales, revenue and expansion generally decrease during a recession. The unemployment rate generally also increases during a recession. While recessions can be painful, they are often fairly short in duration.
Brent Little, founder of Odyssey Wealth, a leading financial and strategic planning firm to the dental industry, states:
“The average recession lasts 17.5 months and occurs every 4.7 years. The longest recession (The Great Depression) was in 1929 and lasted 43 months. The second longest was the Great Recession of 2007 which lasted only 18 months.”
Thus, historical data seems to suggest that we are long overdue for a recession, but it will likely only last no longer than 18 months in duration.
UPDATED COMMENTARY: This analysis all still holds true today.
Potential Risks of a Recession
Some of the potential risks of a recession to the DSO industry are:
1. If patients will stop going to the dentist and harm practice revenues;
UPDATED COMMENTARY: Dentistry has proven time and time again to be virtually recession proof and now virtually pandemic proof. There does not appear to be a realistic risk of patients ceasing going to the dentist for economic or pandemic related reasons. However, there are indications that the volume of certain cosmetic dental procedures that involve discretionary spending are decreasing due to the current economic conditions. Therefore, a segment of overall dentistry that relies on discretionary spending may feel some affects from a potential recession but overall, the dental industry remains strong, and patients should continue to go to the dentist like they have through other historical economic downturns.
2. If banks stop lending money to practice owners and investors;
The lending environment has clearly tightened up and the cost of money has significantly increased. In general, it is harder to obtain credit and the increased cost of credit generally reduces the amount of spending power for practice owners and investors under credit facilities. So far we have not seen it affect transactions in the 1m to 15m range, but several larger transactions have been cancelled altogether or reduced in scope already this year. It has also been reported that several middle market DSOs have had some limits placed on their ability to do larger transactions and in some cases all transactions. At this time the most significant impact appears to be with larger transactions, but this is something that should be watched closely over the next several months.
3. If private equity funds will be unable to invest in the DSO space;
UPDATED COMMENTARY: Nothing that has occurred over the last 2 1/2 years has reduced the demand by PE groups to make investments in the DSO space. Unprecedented demand still exists but as discussed above the increased cost of money is negatively impacting some of the potentially larger transactions and we may see some deals get temporarily postponed this year until conditions improve. However, many PE groups and family funds have significant cash to deploy and will not hesitate to do all cash deals for highly sought-after groups. However, on the whole there may be fewer overall bidders for transactions until the current economic conditions improve.
4. If practice owners will be unable to sell their practices during a recession; and
UPDATED COMMENTARY: Solo and group practices with no material financial or regulatory issues in the 1m-15m range should still be able to achieve near maximum value for their organizations. However, some larger groups or groups with certain financial or regulatory or operational challenges may not be able to achieve maximum value until the conditions improve. It may be best for some of the negatively affected groups to postpone a transaction until conditions improve while others may still be able to achieve substantial value now depending on the particulars of the organization and the amount of potential available buyers in the market at the time of the sale.
5. How the timing and value of second equity events may be affected during a recession for sellers who have rolled over part of the purchase price for shares in the DSO entity.
UPDATED COMMENTARY: Late last year and earlier this year we saw several DSOs go for near record multiples but as we crossed the halfway point of the year several larger transactions have been placed in a holding pattern until the economic conditions improve. This requires rollover equity holders to wait a bit longer (likely 12-24 months) until they realize the proceeds of a second equity event. This is also a trend that should be watched closely over the next several months.
Potential Mitigating Factors
The following factors might make a recession less painful for the dental industry:
1. If, similar to the Great Recession of 2007, patients continue to go to the dentist and the dental industry, in general, thrives;
UPDATED COMMENTARY: This is largely expected to happen with the possible exception of certain cosmetic procedures that involve discretionary spending.
2. The dental industry taps into its enormous growth potential to offset some of the harm caused by a recession (an estimated 60 percent of the population does not go to the dentist and represent an extensive untapped resource);
UPDATED COMMENTARY: There are many innovative programs in the works that if successful will further tap into the enormous population that currently does not go to the dentist. This is something to watch closely over the next several months.
3. Many investors conduct all-cash deals and do not rely on bank financing;
UPDATED COMMENTARY: For strong dental organizations that are in demand PE groups and other investors will not hesitate to structure all cash deals.
4. The demand for dentists continues to outstrip the supply of available dentists which makes mass unemployment of dentists unlikely; and
UPDATED COMMENTARY: The demand for dentists is at an all-time high and that is not expected to change in the next several years and it is even likely that the shortages will increase as more dentists retire. So there should not be any material risk of dentists and other clinical professionals being unemployed in any great number.
5. Most recessions last less than 18 months.
UPDATED COMMENTARY: This still holds true today.
Conclusion and Analysis
Based on the available historical data, and a review of the likely risks and mitigating factors present in the dental industry, it appears that:
- A recession is overdue to occur sometime in the next one to three years;
- A recession will likely last for less than 18 months;
- Current DSO organizations that are struggling or are only marginally successful may be financially vulnerable;
- Some lenders may scale back their lending activity or become more selective during a recession, but it is unlikely that the lending markets will completely collapse as they did in the Great Recession of 2007;
- Some investors may scale back their activity during a recession while others will use the recession as an opportunity to conduct all-cash deals and achieve above-market return;
- Strong financially-sound practices should still be able to be bought and sold during a recession, but at a potentially reduced multiple;
- Weaker practices may have to postpone an equity event until the end of a recession; and
- Practice owners who previously sold and rolled over part of the purchase price in shares of the new DSO entity may receive a lower-than-anticipated return if an equity event occurs during a recession, or they may see the second equity event postponed until the recession is over.
UPDATED COMMENTARY: We may already be in a recession, and if not, one is likely imminent in the next few months. All of my other observations from 2020 hold true today.
While no one can state for certain when the next recession will hit, there are a few things you can do to prepare for it now. Brent Little recommends that:
- On a personal level, you should have one to two years of available cash for short term needs;
- On a personal level, you have a diversified portfolio that can withstand a 10-30 percent drop in the stock markets; and
- If necessary, you can postpone an equity event for 18 months to two years if necessary.
Overall, the dental industry remains very strong and if history is any indicator, it seems unlikely that any negative effects from a recession will last more than a relatively short period of time. Over the next seven to ten, years, the great consolidation of dentistry is likely to continue mostly unabated with many commentators predicting that DSOs will comprise upwards of 80 percent of the market by 2030.
UPDATED COMMENTARY: All of these observations and recommendations from 2020 hold true today.
Brian Colao is the Director of Dykema Dental Service Organizations Industry Group. Brian has been serving the dental industry for over 25 years and is widely regarded as one of the foremost authorities in North America on DSO formation, DSO business structures, DSO related mergers and acquisitions, and the full array of regulatory compliance requirements for DSOs. His knack for law and mentoring others has made a strong impact on many DSO professionals, and thousands have relied on his guidance. In 2019, he was one of only seven individuals and the only attorney selected for inclusion in Group Dentistry Now’s “DSO Influencer’s List.”
Brian speaks at dozens of conferences each year and appears regularly on multiple podcasts and interviews covering a variety of topics. Under his visionary leadership, Brian spearheaded the creation of Dykema’s award-winning Definitive Conference for Dental Service Organizations, which many consider to be the industry’s leading DSO conference. Since its inception in 2014, it now draws more than 1,500 attendees and represents a “who’s who” of all segments of the DSO industry.
More contributions from Brian Colao:
- The Great Evolution and Consolidation of Dentistry During a Potential Recession – Group Dentistry Now
- The Group Dentistry Now Show: The Voice of the DSO Industry – Episode 76 – Group Dentistry Now
- 18 DSO Industry Thought Leaders Share 2021 Reflections and 2022 Predictions – Group Dentistry Now
- The Group Dentistry Now Show: The Voice Of The DSO Industry – Episode 26 – Group Dentistry Now
- 6 Keys to Recovery of the DSO Industry After COVID-19 – Group Dentistry Now
- Inaugural ‘DSO Influencers to Watch’ List Revealed! – Group Dentistry Now
- 2019 Recap & 2020 Predictions from 18 Dental Support Industry Thought-Leaders – Group Dentistry Now
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