87: The Truth About Private Equity — 5 Things You Should Know Before PE Firms Invest with Ken Kaufman, CFO, National Dental Partners

Welcome to DSO Secrets. I know what it's like to be an entrepreneur in the dental industry. I've had my ups and downs, just like you. There's so much opportunity to be excited about, but so few resources to get answers. From here on DSO Secrets, we get you those answers so you can change the lives you're meant to bless and achieve your personal success.

When I was working as an associate

right out of school, I never imagined I could own these many practices with this amount of support. So thank you.

You have helped build my marketing mind

to a whole new level.

You have this natural talent, this unique ability.

Well, hello, everyone, and welcome to another episode of DSO Secrets. I'm your fearless host, Emmett Scott, and today I'm so excited to have Ken Kaufman on CFO of National Dental Partners. Now we'll have to have another podcast just around that name change that happened. But, Kim, we have so much conversation that happens around private equity. And as we have these entrepreneur dentists who continue to look to grow and expand, obviously having access to capital is a critical part to that. It's a fuel that allows us to access acquisitions de novos, etc. And so I thought it would be great if we did something around the truths of private equity. All right, so you ready for this?

Yeah, absolutely. Let's jump into it.

Okay. Here's a couple that I've written down. You can give your feedback as well. Number one, they don't want to buy you out. So many times I hear people say, well, what happens when private equity comes in and it wants to buy me out and take over, and then I've lost my dream and my vision? Or, you know, if we have a partner and they say, well, what happens if private equity comes into National Dental Partners? You know, what happens there, et cetera. So talk us through that. You know, we always think about the guy who says, oh, yeah, private equity came in, bought me out, and I made a bunch of money and I left. It kind of creates this idea that private equity wants to come in, buy everything, and kick everybody out. Is that their intention? And if not, which I don't think it is, why not?

Well, it's not. And I'll tell you, there's several reasons why. Here's the primary one, if they kick you out, who in the world is going to run this business moving forward? Who's going to be the visionary? Because that if it's you, if you've got a management team or leadership team around you, you guys have the secret sauce. This is a people business. This is a service business. And so the last thing they're going to be able to do is come in and roll up their shirt sleeves and run your business. And here's the second worst idea that I have seen. We've seen this tried before, is where sometimes private equity will find some health care veteran CEOs and business people, and they'll bring them in as what's called operating partners to kind of take over the business. But again, this is your heart and soul. This is your entrepreneurial baby that you gave birth to. And it's your vision sliding somebody else into that CEO chair, sliding somebody, you know, three or four other team members in to kind of take over an operational or finance, you know, executive role that is really choppy and it is really messy. And so, generally speaking, they don't go there.

So when I hear people say, hey, what if we all combine together, will sell to private equity and we'll leave, or, hey, well, you know, I don't want to bring in private equity because then I'd have to sell out everything and leave. That's actually not true. They're going to want you to what they call roll your equity going forward. Right. They want to keep you in. And in fact, if you've talked to private equity, one of the things they're most concerned about is, hey, if we buy you out too much, do we lose all the motivation? I mean, this is a human game, as you said. And it's not just human, like, have enough bodies in the chairs. It's like, do I have your heart and your mind really showing up every day, or did we just make you so rich that you don't care anymore about the outcomes? Right?

Yeah, that's exactly right.

All right, truth number two, they don't want to control the clinical or destroy the wisdom you've created. So this is definitely one that. And we'll get down to some other truths that I think have fed into maybe a myth that they do want to control it. But why is it that they don't want to control the clinical? I guess, how would they control the clinical? At the end of the day, it's

actually illegal for them to try to control the clinical, and they're just not

involved enough to actually be like, hey, on that tooth, I was thinking you should do a filling or something.

Yeah, it's not their strength. I mean, these are. I mean, they refer to themselves as the spreadsheet monkeys and, you know, the finance gurus that they. I don't. I don't see a place now if you gave them enough data to look at and if they had, you know, time to kind of process through and really get to understand how a clinician thinks, you know, they could probably start to try to draw some inferences. Especially if you had some comparisons like this clinician does, you know, this amount of crowns versus this clinician does this amount, and they're the same patient types coming through, they could probably start to try to draw some inferences, but still, they would have no idea how to communicate with a clinician or influence a clinician. And yeah, there's just. It's. They don't want to do it and they know they can't do it.

All right, awesome. So other than being illegal, they also have no capability to actually do it. All right. And they don't want to destroy the wisdom because that, as you pointed out in this first one, the same reason they don't want to buy you out is they actually want to keep all of the secret sauce in the company. Right, exactly right. All right. This is going to be a weird one for some. They want to keep a great culture. Now, what's the metric that drives that? Because you referred to them as spreadsheet monkeys. I'd love to say that it's because they're so in tune with human nature and so forth, but there's actually a metric that culture aligns with. Do you want to talk about that?

Yeah. So, I mean, there's two. The first one could be a net promoter score, but that even is still the telltale sign is what is your turnover rate? Are people staying? Are they engaged or is the company growing? And is that lifeblood of cash flowing in? All of that circles around this concept of turnover. And are people staying and wanting to stay and be engaged?

We've talked to high end investment bankers who talk to private equity firms, and one of the big numbers they look at is your turnover of clinicians. They believe that keeping clinicians is critical to the business. So we have to give them credit that they do understand where the bread is buttered here. And they actually get really concerned if you're not able to retain associates and add associates and grow associates. All right. They want clarity on the vision for the company. Now we're going to get into some of the maturity things that I think sometimes people shortcut and say, see, this is where they're trying to control, but they're making this investment and they actually want some clarity on the vision. What's the pressures on them that they would want clarity? I mean, it kind of Seems obvious, like if I'm making an investment, I kind of want to know where we're going. But what are some of the pressures and reasons, tactical reasons that they need to understand where the business is going?

Yeah. And it's interesting because when you are working with a private equity firm as an executive, you'll find that their list of questions for you is exhaustive. And if you have an open meeting with them, they would like to just keep asking questions, keep asking questions to understand the business. And the reason why is because they have customers. Their customers are what they refer to as LPs or limited partners in their funds. And it can be anywhere from an individual who has gained high net worth through their own type of business, something or an inheritance. It could be large pension funds and what you call more institutional investment groups or family offices. And these are people who are investing with this private equity group because they're saying, hey, we know alternative investments. We're not stock market. We're going to go get better returns. There's higher risk in this, but we're going to get a better return than that. Stock market portfolio is going to get the s and P500 or, you know, whatever index fund. So they then in turn have to show that they know how to select the right businesses to buy and then they know how to lead those businesses if they're in like a board control type of a role and at a DSO level, that they're going to lead that business to be successful and produce a return better than what these investors have. And you know, these big funds, they have a small portion of their portfolios that they set aside for alternative investments and for private equity because they know, hey, there's high risk, but that could juice the overall return of my portfolio. So they have customers and those customers trust them with this money and they need to dig in, know and understand the business because. And they don't want to. This isn't just paying lip service, but they need to be able to communicate to those LPs what's happening in this business and what is the vision? What's the plan? How is it going to grow? Why are we excited about being invested in this business?

Yeah. Great. So I think it'd be worth kind of teasing out because a lot of people haven't been in the financial planning or investment banking world. You touched on it. But I just want to call this out is if you can imagine, as Ken said, there's high net worth individuals who've built up a portfolio of capital and they'd like to invest it. And they have only so many choices, right? Like the stock market or individual stocks. They can go into bonds of various types and flavors, or as Ken said, they can go into alternative investment groups. That's usually like real estate, we often think about, and privately owned businesses. Right. And so dental practices fall into that. Well, they don't have the ability oftentimes the staff, the, that goes out and finds all these different groups. And so that's what private equity has solved for them and said, hey, we'll go vet and do all the due diligence, we'll find good businesses to invest in and then we'll bring those back to you. And like you said, Ken, sometimes it's high net worth individuals, sometimes it's like all these pension funds that we hear aren't making enough money for how long people are living. They're looking to try to make enough investments so that they can grow enough. And sometimes the stock market's not enough. The real return is down in the entrepreneurs. Right? That's something that we push. All the value in America is built off of these entrepreneurs. And so they're trying to get to the heart of that. Now, not every entrepreneur is that good or we just fall on bad times and we mess things up and it explodes. So they're having to figure out how can they vet to pick as many winners as they can. Anything you'd add to that?

Yeah, that's exactly right. And the only thing I want to add is I used the term spreadsheet monkeys earlier. There's a hierarchy in private equity firms, just like there are in your business. These are recent grads from business school that come in and they do a bunch of analysis and spreadsheets and they run the numbers, they look at your same store growth and they do lots of comparisons and then they feed them up to some of the higher level associates and then that goes to the partners. And ultimately the partners are the ones who are out there talking to the LPs and building that relationship. And so the reason I bring that up, Emmett, is because it's really, they're organized in such a way so that they have partners that, you know, they, they were back down, they're doing all the spreadsheet stuff, but now they've done enough deals, they've gotten experience and they've shown a track record of being successful and grown up sort of in the private equity world. And then they can turn around and then communicate to their customers and win the trust of their customers. Somewhat, it's somewhat backward Looking like, hey, I've, I've had a successful track record, but also buy into how they're going to step away from whatever. You know, they used to be doing the spreadsheet stuff, now they're going to go run a portfolio company or sit on the board of a portfolio company and that it's a next step up. And, but anyways, that's how they're organized and that's where the decisions are made and how the communication all flows.

Yeah. And we're grateful that they're vetting these companies. Right. Because if they're making investments in poor companies, then things like retirement plans completely fall apart. Right. If they're just willy nilly making investments. So we want integrity in the system. Of course, being the one that's being interrogated can oftentimes feel overwhelming and frustrating and feeling like, man, why are you asking so many questions? Which gets me to the next one that I think hits on a lot of people. They want clarity on the financials. Surprise, surprise, they're making a financial investment and they want clarity on the financials. And probably one of the most frustrating things for them in this space in dentistry is the financials are just oftentimes so poor.

That's right.

So they know that there's good investment, they know there's good managers, they know there's great clinicians, great leaders. But they look through the keyhole of the financials to understand the business. They're not operators. And even if they, even for myself as an operator, the financials, clear, clean financials can tell you a lot of the story. And so they do, they put a lot of pressure on having good financials.

Well, and you've said this before, Emmett, I'll quote you here, but the financial statements are the lens with which they look through to see your business. And it's how they think and how they interpret how the business is running. And you know, we've had experiences, I mean, you and I, arm in arm, side by side, where a private equity firm is telling us, wow, you guys had a great quarter. And you and I are like, oh man, we just got our trash kicked this last quarter. And we had this and this and this and all the emotional roller coasters of up and downs. But they have this ability to not be involved in all that day to day and they just, they can look through that lens. And we're like, man, we had such a rough quarter and we got so beat up. So anyways, for what it's worth, it

can go both ways. Right? You're like, they can say, oh, man, why didn't you hit this number? I thought you guys were on track for this. And you're like, I'm just glad we're alive. I'm just glad we made it through. And as they get more educated and as you have better communication, you have to treat them like a customer, right? Just like you would your bank or anyone else. And again, I'd say for anyone who says, well, that's dumb, or that's too much work, or, why do they have to ask all these questions? I. I just say, hey, if you walked into your bank and they said, listen, we really haven't managed our portfolio well, so your checking account is drained. It all fell apart. You go, say, what? So these guys have a stewardship that they're responsible for in order to make good investments, and it puts additional pressure on operations to mature up. That's why you have a CFO to handle that customer, so that you can handle all the other noise of taking care of clinicians and taking care of patients.

That's right. And I'm going to. Sorry, I've got to just hijack this for a second. I got to drop in a bonus truth here. And it is deal flow. So private equity, it would be interesting to, you know, to do a recent poll on this, but they often will look at hundreds of deals before they do one where they're doing all this analysis and those things and everything is through this lens of the financial statements and how that's being presented. And it's not that, you know, everybody just presents. Should just present their truth, you know, of what's going on in the business. But there's ways to organize it and ways to communicate around it. And again, just. I'm just trying to emphasize that they have so much deal flow coming through, and they do so much analysis before they finally get to one company where they feel like it checks all their boxes, and they see it as an opportunity and they can add value and give good advice to the leadership team and help them really.

And they have to compete against the other private equity firms to try to get the deal right. In talking to private equity, you know, numbers that I have heard that they've told me is between 150 to 300 deals they have to look at to do one. You know, between. Between finding actually quality companies that can, you know, have a management team, have a business model that's meaningful, have financials they can actually get their arms around, and then trying to win it against other private equity firms, you know, that Also say, yeah, this is a great company.

So they have to have, with all this deal flow, they have to have some level of, hey, it's got to meet some standard on the financials or we're not looking at it and we're kicking it out. And so it's super important to understand that that's their lens and it helps them really see and then be able to grasp anything else of vision and everything else that's going on inside of, you know, where you're taking the company.

It's awesome. Okay, well, speaking of deal flow, next truth, they want you to grow. Now there's a lot of pieces. We started talking about this on growth. They want same store growth. Right now, same store growth is the most ideal because if you're growing by taking care of more customers, of taking care of that community, you're increasing demand there. One, it's the least expensive investment to make. It's simply continuing to add, you know, more clinicians, which is something I don't think people realize. They love if you're supporting more clinicians, they love if you're supporting more patients. Right. Because obviously that means you have a growing business. So they want same store growth and

especially Emmett, if it's in the exact same box, because you, you have that fixed cost and so you have all that margin coming through. Fixed cost is already covered. And so it improves the profit margin and the overall profitability of not just that store, but then it flows over to the entire group of affiliation of practices.

Yes. Great. And then number two, they get growth through leverage. So they will. Leverage is another term for debt, some kind of debt. So they'd rather not put any more money in after they've invested in. If they can use leverage, the leverage will get paid down over time. It's really no different than what you and I, Ken, might use to buy a home. We use leverage, right. In order to get into a nicer home than what we could afford just from our bank account. And then over time we pay that down. And guess what happens is we pay down our debt, the equity goes up, right? So the equity of the home goes up. And so if the value of the home's moving up and we're paying down the debt, then our overall equity is growing. And then if we're an investor, we borrow more against the house and build the house bigger. Right. And make it worth more. And then we pay that down over time. Especially when you have a revenue generating asset, you want to borrow, pay it down, borrow, pay it down. If your goal is to have a bigger impact and get a higher return. Yep.

And one thing that's, this is a positive and a negative about leverage. It accelerates outcomes. Meaning if you, if you leverage the business and, and that then what happens is it enables you to grow more and faster. It means their return on the equity they put in is going up because they ultimately want to drive return.

And your return on your equity is going up too?

Oh, absolutely. Everybody's benefiting. Rising tide floats all boats here. But if for some reason it goes sideways, you've got this big debt to pay. And if your EBITDA or your cash flow is going down for some reason, or there's struggles inside the business, you can get sideways and could ultimately lose everything. And so leverage is a tool to try to maximize or accelerate the return of the business. Again, because everybody who owns a business are like, well, do you want to make 15% or 20%? You'd say 20%. Well, great. So we need to introduce some leverage, but there is some risk associated with it. But generally speaking, I mean, there are debt to equity ratios that banks are comfortable with, funded debt to EBITDA ratios. That's more of a cash flow basis, but that's how banks get comfortable lending. And then knowing that a private equity is behind that, they're like, hey, this is good because they've got, they put a lot of equity in, we're putting our debt in. This is going to accelerate an outcome for them. And that private equity firm is going to, you know, has, is super motivated, make sure this is all successful.

Good. Ken, just kind of as a Finance 401 class here for a second. And just as a general discussion, why do you think most banks are comfortable up to about a 4 to 1 debt to EBITDA ratio? Meaning for those who might not know, we'll assume you know what EBITDA is. Otherwise you can listen to the five or ten podcasts Ken has done to really help drill down on that. But if you've got a dollar of EBITDA, you can go borrow about $4 max, three to four dollars from most senior lenders. Is there something magical about that? Is it just that three years of risk that they're willing to take? Four years of risk is how they think about it.

Yeah. And here's the thing in our industry, so some of it's risk, but here's the deep dark truth of it all. They hope that if they have to take over the asset because it's gone into default and they have to foreclose they hope to sell it for four times and get their money back.

Got it. And so they're really just looking at what most single practices are trading at. And so they say, okay, well if everything falls apart, I can at least sell the practice to some other dentist for this is what kind of markets at that makes sense.

And again, and remembering that EBITDA only represents cash flow, the challenge you have is also if they held onto the asset and it stayed right at that 4 to 1 ratio in four years, they would have themselves paid off and they could move on. But generally speaking, and again, if private equity isn't good at coming in and operating a healthcare business that's retail focused like dentistry is, then banks are going to be even less qualified to come in and do that. And every banker I know, they'd happily say, yeah, okay, you're good at running the dso, I'm good at being a banker. And so a bank running a DSO that just doesn't work out. And so generally it's because they would be liquidating practices, just like you said.

Yeah, that makes sense. Okay. Oh, and then the last one is they would use their own investment, right. So they will use their own dollars, but they like to hold off on that because now their own dollars need to make a higher return. And so they only want to reserve those for the best deal.

And there's a couple strategies there, Emmett. If you are going to work with a private equity firm and you do need capital, you got to plan that out up front and be clear with them and not think, oh, you know, in a couple of years maybe they'll put this money in. Because they don't think that way. Every dollar that comes in from their LPs they're putting to work. And generally speaking, there's a term called dry powder in the private equity world. They usually keep some dry powder on hand. And it's if a company is really, really struggling and they've got to put some money in to sort of help get something turned around, they keep that in their fund. Otherwise they're generally not using that fund to fund existing companies. They generally are. You know, they deploy that fund and then they go raise a new fund and then they go get new companies. Unless it's been something that's been before you sign up with them, it's been strategically allocated and lined out for some purpose like that.

Right? Yeah. So can you go into my last two points here that I think are worth talking about is number one, these are a couple tips as you talk to private equity make sure they have experience with healthcare providers. Now, I think the big thing here is there's a lot of PE firms that are excited about being in dental, but we've just found that. And some will say, oh, yeah, I've been in healthcare. I invested in this technology firm that helps with revenue cycle management, that helps a hospital or whatever. But working with providers directly, understanding the nuances that you do have, providers that you have, the stack of humans just helps them have a little bit more empathy and a little more understanding of regulatory and compliance things that are so important. I think there's just an overall appreciation for the things that you're navigating. It's always good to have a financial partner who appreciates that. Point A to point B isn't quite that simple, that there's a lot of steps in between that have to be thought through and respected in a DSO environment, because we are supporting clinicians.

Yeah, that's exactly right. And one of the main reasons, too, Emmett, I'll add on to why it would be important for them to have that experience is because they also will have a high degree of respect and they'll try to figure out how they can best support keeping the business people in the DSO aligned with the clinicians in the dso. Because that is where a lot of the value of a DSO is, is the ability for the DSO to say, I'm supporting these clinicians. Clinicians to say, I want their support. I like the support that they bring. I want to be a customer of them because they do a great job and they bring me the momentum that I need and my other fellow clinicians need, whether they're associates or partners or whatever. And so somebody who's been the rounds a little bit in healthcare will not come in and get in the way of that. Rather support that relationship to continue to strengthen and get better.

Yeah, they'll appreciate that. If you're the CEO or cfo, a dso, that means that you have a huge customer called clinicians. And so even though you might have an executive title, you're really second tier because your customer is the clinicians and then the patient. So maybe we're third tier and all of it. All right, last one here. Make sure the fund is big enough to scale with your vision. So this kind of goes along with what you were saying, Ken, is make sure that if your thought is, man, I want $50 million in that you're not with, let's say, a fund that's 300 million, because that fund is going to have what we call Concentration risk. They can't have that much money in one customer because if you fail, it will destroy all of their returns across the rest of their portfolio. And again, kind of my bank account analogy, you wouldn't be thrilled if your bank account was drained out or you had zero return. And so they have to break out their portfolio with a risk mindset. So if you're planning on growing very quickly, just know that you're going to need to have a fund that's big enough to meet that growth need. And I love what Ken said and design up front that that money's already allocated and ready to go. I mean, in good investments, they want to allocate as many dollars as possible. What a lot of people don't know is if a fund is, let's say, a $300 million fund, that fund isn't making any money until they deploy capital. So as they're searching those 150 deal flows to find that one diamond in the rough, they're not making any money during that time until they deploy the capital and then they get paid for that. So they want to make investments, they want to get their fund all invested out, but they can't have concentration risk.

Yep, that's exactly right. That's exactly right.

Good, Ken, anything else with private equity? I think this is a good one. As we break this down, you know, there's just so many things in entrepreneurship and business that we simply oversimplify and we talk about, and I think we. We actually believe we understand to some degree. It's like the number of people that feel like they've read Seven Habits of Highly Effective People just because we've talked about it so often, like, well, I've never read it, but I just really like those principles. You know, I think private equity is one of those, and we really wanted to deconstruct it. I'll end with this thing. One thing I've often heard people say is, man, private equity is coming in and doing X. And what I would say is, if you really look at the chain of events, private equity will be invited in to do X. If a dentist ever said, we don't want any more support, we don't want any more capital to open up these practices. There will be no place for private equity. They don't get to come into places. They get to be invited in by the entrepreneurs and by the leaders of that space. So no one should ever feel like something's getting forced on them or on their industry. The only reason that private equity was ever invited in was because there was some dentist who wanted a bigger support team and needed capital to be able to drive their vision. So you know, know that you are in the driver's seat in all of this, that you are empowered. I will end with this one last is private equity is another company. They each have their own cultures. Find the one that fits your culture. Some of them aren't going to be a good fit. Not because they're evil, maybe they are. But because they're just not aligned with your culture. Just like any team member could not be aligned with your culture or any vendor could not be aligned with your culture. You're going to want to take the time and get less focused on the money and more focused on the humans

because you're really, you're going to be business partners, right, Emmett? And you're going to be having monthly earnings calls. You're going to be having quarterly board meetings where you're sitting across from them. And they're going to come into town the day before so you can catch dinner that night, you know, the night before your board meeting the next morning. And these are going to be people that your business partners with. And so you have to be, you have, don't. It's not about find one that will give you money. It's about no find the right one that you can build a relationship with and that you want to be partners with.

Awesome, Ken. Thanks for doing this with us. I think we continue to help educate. We'll have some great discussions over on the DSO Secrets Facebook group, the private Facebook group. So if you're not a part of that, come in, make some comments, ask additional questions. If you're going through this journey right now, we'd love to hear about it. Love to get your comments, what questions you have. Let's support each other in all of this. And until next time, keep smiling.

Thank you for listening to DSO Secrets. Join our community on Facebook at DSO Secrets and get answers and resources to some of your most challenging questions. If you want to get a copy of the seven secrets of any DSO, go to our website at dsosecrets.com and we will get that emailed to you. Remember, don't go at this alone. Let us be your team while you build your team.