Is Group Practice Equity Already The Next Tulip Bulb Craze?
WTF was the Tulip Bulb Craze?
The tulip bulb craze, historically known as Tulip Mania (or Tulipomania), was a period of intense financial speculation in the Netherlands during the Dutch Golden Age. Often cited as the first recorded speculative "asset bubble," it reached its peak between 1634 and 1637.
While valuations for individual practices remain at or near all-time highs, it appears as though the market may be starting to cool off a bit for certain practices - especially those that are not as “center of the fairway” as others.
The last decade, and more specifically the post-COVID era, saw both a groundswell of new groups being formed and, not surprisingly, a flurry of (irrational, to me) buying activity. This behavior saw valuations bloom to new heights and structures pivot to increasingly more creative and complicated solutions as buyers stretched for relevance and differentiation. All sorts of new acronyms have been created to describe group practices.
Was any of this healthy? Maybe. For some. Especially for doctors who were able to fully cash out at premium valuations. It was absolutely a boon for dental practice brokerages which have also increased in both number and size. Econ 101 - supply meeting demand.
But just how “premium” are any of these group valuations when you start peeling away the layers of the onion?
Industry lenders have done an increasingly astute job of trying to contain the cash being paid at close - agnostic as to the overall valuation. What does this mean? It means that the non-cash consideration (aka “paper” - seller note and/or equity) in many deals became an increasingly larger portion of the overall pie. Debt instruments are usually easy to understand. Equity on the other hand?
Cash on Cash Returns/Multiple of Invested Capital (MOIC)
The grandpappy of investor bragging rights. IRRs might help raise that next fund, but MOIC is where wealth is created.
In the current market, many private equity investors are realizing and putting money to work in transactions at historically low returns. This is due largely to platform pricing holding firm while the market for leverage has curtailed in amount (lower leverage covenants) while increasing in cost (fees and rates). You may have witnessed the increase in Preferred Stock issuances, usually a tell that a global recap of the platform did not go as expected.
Said differently, it is simply much more expensive for PE investors to put money to work right now. Some have even gone pencils down on new platforms. One of the reasons so many group recaps have not performed as well as expected of late.
Many investors cite “base case” MOIC expectations as low as 2.0x. Here’s the rub, beating the house (private equity) is highly unusual. So, if you are exploring options with a group that includes equity, it likely behooves you to dive deep into their equity story. How much of the overall value is coming from the equity tranche or back-end/second bite? Dig deep into the assumptions around that second bite. What does it look like doubling your money versus what the group is trying to sell you?
While there are always exceptions, get curious about anyone trying to sell a MOIC >2x. Also, be on the lookout for the next recap horizon. The equity in deals done immediately before a recap event often doesn’t perform as well - largely due to timing and how it is priced. If you are <1 year out from a recap and you otherwise like the equity story, you might be better off taking that value in a seller note and exchanging it equity in NewCo when larger business recaps in the near future.
This discussion is not intended to differentiate between TopCo/Parent, JV/SubDSO, or Hybrid models.
Decent read:
https://www.mckinsey.com/industries/private-capital/our-insights/global-private-markets-report
What to look for in “Equity Stories”:
- When was the platform formed?
- Are there professional investors (private equity) in the business already?
- Has the platform been through a recapitalization (“recap”) event? If so, what was the outcome?
- How long has the platform been with the current owner group?
- Have there been any dividend recaps along the way?
- Time horizon to the next recap event? Expected outcomes for investors?
Good luck, have fun, don't die! (fantastic movie BTW)