January 03, 2023
How to Weigh the Risks of a Private Equity Offer
For dental practice owners looking to sell, a private equity deal offer may be enticing. However, it’s important to assess the three types of risks you’ll be faced with when considering the offer: risks you can control, risks you can influence and risks you can’t control.
When making any investment decision, consider that risk and return are correlated. We should not expect safe investments to provide the same returns as riskier investments, and we also would not accept low expected returns when taking on more risk. Here are the sources of risk you should know about to make sure they align with your return assumptions.
Risks you can control
Cash at closing (minus PIK): The cash you receive at the closing table is yours to keep and invest based on your risk tolerance and financial plan. If there is a payment-in-kind (PIK) element that is reinvested as an equity roll, this amount should be excluded from your financial plan.
Salary: The payments you receive as salary are also under your control. Like deferred compensation elements, you can choose to terminate your employment arrangement and forfeit these dollars.
Bonus: You can also directly influence any bonus assigned to your specific clinical performance as part of the deal. If you choose to continue to grow the practice, financially you and your team can control the likelihood of these payments being released.
Deferred compensation: As your taxable income will be lower in future years, an element of deferred compensation can be a tax-effective way to realize sale proceeds over time. Deferred compensation should carry no performance threshold or incentive, but your willingness to remain a clinician for the private equity group will determine if these payments are received.
The above risks are ones that are under your control. The next level of risks you may be exposed to are shared by clinicians in the larger group practice.
Risks you can influence
Group growth rates: Practice values are a product of cash flow. When you enter a private equity deal, you become part of a larger organization. The value of the second deal will be based on the revenue the group practice is recognizing at the time. As such, there can be incentives at the group level to grow revenue and profitability. Even if you are in a growth phase and eager to expand your practice size, your fellow clinicians may not be in that same position. Conversely, if you sell your practice as way to exit clinical work, you may not be as motivated to grow revenue for the private equity group as you were for your own practice. Both the second sale and any group-based financial incentive should be viewed as contributors to these financial outcomes.
Earnout notes with targets: Some earnout notes contain revenue targets. This revenue target is usually set at the private equity entity level. If your earnout note contains these targets, you won’t have total control over releasing these funds.
Add-on EBITDA: This element tries to attract more clinicians into the initial deal size. Often dealmakers will lean on you and your professional network to identify other viable practices. As such, you will not be in full control of achieving add-on earnings before interest, taxes, depreciation, and amortization (EBITDA) goals, but you can influence the likelihood of hitting these targets.
Some risks associated with a private equity deal can’t be controlled. You should understand these before signing the term sheet and entering a deal.
Risks you can’t control
Second sale: A sizable portion of the value of a sale to a private equity firm is associated with its exit strategy, which is when it in turn sells the initially aggregated practices. It is rare for someone who is not a founding member or initial investor of a private equity firm to be offered a board seat or controlling interest. As such, the private equity group will not need to consult you on the value or timing of the second sale. The private equity group will work diligently toward maximizing its (and thus your) return, but there is no certainty on the value or timing of the second sale or if it will occur.
Market multiple: The value of the second sale is generally a multiple of your return on investment or an assumed multiple of the private equity group’s EBITDA at a point in the future. Deal multiples are a factor of supply and demand, current market forces and underlying interest rates, all of which are outside your control.
When financial advisors work with dentists on these opportunities, they review multiple scenarios and model how these will affect the practice owner’s financial plan. It is important to consider that much of the value of a private equity deal will be outside of your control.
This blog is the second in a three-part series intended to educate medical and dental practice owners about private equity transactions. The first explores the basics of a private equity sale and explains the key terms you need to know. The second gives an overview of the different types of risks associated with a private equity sale. The third explains how to assess if the deal fits into your financial plan with a hypothetical example. This blog series is for informational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Individuals should speak with qualified professionals based upon their own circumstances. R-23-4482