DSO Lending Landscape: 2021 and Beyond

If we learned anything in 2020, it is that the dental industry is extremely resilient and filled with opportunity.  Who would have thought that in March, the government would order dentistry to halt for several months while we navigated a new world of face masks, Zoom calls and PPP loans, while still finishing the year with many general and specialty groups showing year-over-year revenue growth?

With the resilience displayed in 2020, coupled with a huge market ripe for consolidation — 2021 appears to be back on track with group dentistry in the driver’s seat.  Private equity continued to invest in multiple DSO platforms in 2020 with many more in the pipeline in 2021, but let’s dive into where banks stand on lending capital to support DSO growth.

Growing Pains Before COVID

Let us first revisit DSO lending prior to 2020.  While we have seen many banks enter and exit the DSO market, one thing remains constant – especially to those looking for a lender — it can be difficult to find that long-term partner.  Banks tend to share the same philosophies in lending to dentists.  Decisions are typically made based on strong cash flow, positive operating trends and the borrower’s character.  The difference is the “when.”

While countless institutions will lend to the single operator or even a dentist owning their first two or three locations, securing a loan becomes more difficult as these groups continue to scale due to both internal and external factors.  For example, most banks have a lending limit. Some banks may not exceed a certain loan amount to a single borrower.  The borrower may have ample cash flow, but because their loan balance exceeds a specified amount with a particular bank, that bank must pause its lending until the balance is decreased.  This is impossible for a company in growth mode, whether they are looking for acquisitions or de novos.  The group practice is then forced to layer future opportunities with different banking partners which can sometimes lead to issues in breaching loan covenants, possibly resulting in loan defaults.  Often banks will provide loans to individual offices and not the entire enterprise, only to later realize a management service agreement is in place.  They discover their lien is on a practice without any cash flow due to the profits being held at the management company.

While it can sometimes be a bumpy transition, there are banks available for the different phases of growth of a DSO.  The best way to navigate these is talking to your DSO-specific attorney or CPA.  They have worked with countless institutions and can introduce you to one that fits your current needs.

The Current Dilemma

Although the dental industry has fared the COVID storm well up to this point, many banks have seen different results.  While most dentists have rebounded after being closed, many other industries have not been so lucky.  Some restaurants, hotels and other businesses remain closed or they’re operating at a limited capacity.  These businesses can no longer make monthly loan payments, even with the assistance of the Payroll Protection Program, payment deferrals and EIDL loans.  As a result, banks are assessing their current loan portfolios and determining current and future loan losses.  For some, this will affect how they lend moving forward.

While the long-term effects are still unknown, we are seeing a shift in some lending programs whether it be reducing amortizations, reducing leverage or suspending a lending program.  Changes in leverage ratios have been the most common.  For example, a DSO whose senior leverage (senior debt to EBITDA ratio) was closer to 4x prior to COVID typically did not fare as well as a platform with a senior leverage ratio closer to 3x.  As a result, the days of traditional lending providing senior leverage at these multiples are likely over, at least for now.  DSOs with higher leverage still have options but will typically come in the form of a hybrid of senior and subordinated debt resulting in higher interest rates or partnering with private equity.  While this is not for everyone, they do have their benefits.

What are banks looking for?

Although many institutions are in a holding pattern or tightening their lending guidelines, many are still lending to DSOs and offering competitive terms.  If your goal is to scale with a lending partner for the foreseeable future, be prepared to provide them with a sophisticated business plan containing, but not limited to the following:

  • Vision and Model: What is your growth plan and how will you achieve this? Will you grow via acquisitions, de novos or a mix of the two?  What is your differentiator from your competitors? Will sellers retire or remain part of the operations?  Will they have skin in the game, i.e., rollover equity or hold a seller note?  What mix of dentistry will you target as well as payor mix?  In what geography will this take place?  How will you drive organic growth?  What is your plan long term, i.e., partnership, exit?  Do you have a pipeline?
  • Financials: Is your reporting sophisticated for a group practice? Are you able to provide financials on a practice-by-practice level as well as consolidated? How often do you track your KPIs?  Do you have a CPA that is able to scale with you?  What is your forecasted revenue, 4-wall EBITDA, and corporate EBITDA over the next 12 months?  Have you calculated your leverage ratios and debt service coverage ratios?
  • Infrastructure: What current non-clinical operations are inhouse and what is contracted out?  Who does your executive team consist of?  What are their backgrounds?  When and who will you need to add to the team to scale with your growth?  What has been centralized and what will remain at the practice level, i.e., insurance billing?  What software is being used?  Who is your external team?
  • Legal and Compliance: Have you legally formed your management company to follow state law requirements? Are operating and management service agreements in place with all entities?  Are you able to provide corporate structure charts?

What is your plan for growth?

As you continue your path for growth in 2021, I recommend assessing your banking relationship:

  • What is working and what is not?
  • Does the relationship feel like a partnership or is it transactional?
  • Do they understand the industry and your vision?
  • Do they have the ability to grow with you?
  • What are their lending limits?
  • What is their flexibility on prepayment penalties if you know you will outgrow them in a few years?

Depending on where you are in your growth phase, whether transitioning to a group practice or have been growing for several years, there is a bank out there suitable for your needs.

Put a plan in place.
We are here to help.

Written by Mike Montgomery
Vice President and Founder of the DSO Division of Live Oak Bank 
Email Mike: mike.montgomery@liveoak.bank


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