When the Tide Rolls Out

Exploring what led to the era of physician practice management "rollups" and a proposed framework for the future

If I had a dollar for every time someone approached me over the past 10 years with an ambitious plan to roll up dental clinics, I’d be dictating this blog from a sun-lounger on my private island. In fact, some of those people are probably on private islands right now… Others, maybe not so much.

While somewhat tongue and cheek, I’m sure most people in the investment community can relate.

The last decade, characterized by low interest rates, readily available capital and "cov-lite" debt—a type of loan that offers less protection to lenders and more flexibility to companies—opened the floodgates for an era of rollups, especially within the physician practice management (PPM) sector(s). This style of investing captured the imagination and capital of healthcare specialists and generalist investors alike, drawn in by the allure of multiple arbitrage and the tantalizing prospect of substantial risk-adjusted returns.

But as the proverb goes, "All that glitters is not gold."

This article is my attempt at:

1. Explaining how the PPM rollup craze came to be;

2. Assessing the pitfalls that many investors fell into; and

3. Offering a framework for how to evaluate rollup opportunities going forward.

Note: For the record, I still really like the rollup model when it’s done well. For me that means an actual value creation strategy (explained below) as opposed to acquisitions solely for the sake of scale and the promise of multiple buydown / arbitrage.

I was spoiled early on in my career with the opportunity to have a front row seat at Heartland Dental, one of my portfolio companies at the time, and witness a masterclass in execution. Their management team, processes and emphasis on culture building set a bar for execution that informs the framework for how I assess opportunities to this day.

The last decade-plus might well be dubbed the "Golden Era" of physician practice management rollups, a time when the healthcare landscape was ripe for change. Fueled by a combination of historically low interest rates and the proliferation of "cov-lite" debt the sector saw an unprecedented surge in rollup strategies. ZIRP (Zero Interest-Rate Policy) created fertile ground for private equity firms and investors, keen to capitalize on the lucrative opportunities that PPMs seemed to offer.

At the heart of this gold rush was the concept of multiple arbitrage. The strategy was straightforward yet very attractive: acquire individual practices at lower purchase multiples, combine them into larger entities, and then sell these “platforms” at a higher exit multiple. This approach promised not just exponential wealth creation for investors, but founders alike who were heavily encouraged to rollover equity into the new, larger platforms.

However, the allure of multiple arbitrage, coupled with an insatiable appetite from investors, created an environment that, in hindsight, might have been too good to last.

It wasn't long before almost every private equity firm with a healthcare portfolio had at least toyed with the idea of a rollup strategy. The potential for compounding returns through seemingly ‘easy’ tuck-in acquisitions became a siren call, drawing in not just healthcare specialists but generalist investors… who previously might have steered clear of the intricately regulated healthcare market.

The irony of the situation is only clear in hindsight. CIMs (Confidential Information Memorandums) that hyped up the prospects of multiple arbitrage began making the rounds to hundreds of prospective investors. This widespread dissemination of what were once closely guarded secrets led to an interesting paradox: the more people knew about the opportunity for multiple arbitrage, the less feasible it became. As the information asymmetry that initially allowed for these lucrative arbitrage opportunities began to dissolve, the market started correcting itself.

For my own mental model, this correction was a reminder of the economic principle that no arbitrage remains unexploited indefinitely. As the secret of multiple arbitrage in PPM rollups became common knowledge, the initial frenzy began to wane, leading many to question the sustainability of such strategies.

Had the healthcare investment community found a genuine path to value creation, or was it just riding a wave of favorable economic conditions? And, more importantly, was history destined to repeat itself?

---

Warren Buffett famously remarked, "Only when the tide goes out do you discover who's been swimming naked." This metaphor resonates profoundly with the current state of many healthcare services rollups.

As the economic conditions that once buoyed the sector have shifted, the vulnerabilities of many rollup strategies are starting to be exposed.

The high tide that many sponsors rode on—characterized by low interest rates, abundant leverage, and the enticing possibility of multiple arbitrage—has receded.

In its wake, a number of rollups find themselves stranded, grappling with the reality of over-leverage and the evaporation of easy exits. The sobering truth is that many of these ventures have become dead weight in their sponsors' portfolios, caught off-guard by the changing tide.

Several factors contribute to this challenging landscape:

Leverage and Interest Rates: The era of cheap, covenant-lite debt is behind us. The interest rates are up, leverage is hard to come by, more expensive, and the lenders, once bitten, are twice shy. For rollups that relied heavily on leverage to drive their acquisition strategies, this shift has been a rude awakening.

Multiple Arbitrage Disappears: The market has become savvier and more efficient. Information about transaction multiples spreads quickly, setting new expectations among sellers. The dentist down the road is well aware of the premium his/her peer received for his/her practice and expects no less for his/her own. With CIMs widely circulated among prospective buyers, the pool of undervalued acquisition targets has dwindled. The asymmetry in valuation expectations that once offered lucrative arbitrage opportunities has largely vanished.

Growth Misconceptions: Many platforms boasted revenue growth, much of which was inorganically driven through continuous acquisitions. While some growth was genuine, driven by increases in patient volume, other critical aspects like price growth and reimbursement risks were often overlooked. The failure to account for these factors has left some sponsors facing the consequences of 'stroke of the pen' risks, where policy changes or contract adjustments can drastically affect profitability.

Rising Costs and Seller Retention: The financial models underpinning many rollups did not fully account for the potential erosion of gross margins or the impact of rising labor costs and operational expenses driven by inflationary pressures. Furthermore, the challenge of retaining sellers post-acquisition has proven to be more complex than anticipated. Negotiations around compensation, which initially seemed straightforward, have become contentious, with sellers seeking to renegotiate terms to preserve their previous income levels. It’s a good reminder that lifestyle is sticky.

---

So far, this article is coming off VERY negative around the idea of PPM rollups. It’s not meant to be. The point is that the “easy money” has been made and now it’s an operators market where execution matters more than financial engineering.

Below are a few things that I look for when evaluating any healthcare rollup opportunity:

1. Evidence of Ability to Pass on Cost Increases: In a sector where costs can quickly spiral, successful platforms demonstrate a robust mechanism for managing and, where possible, passing these costs onto payers without sacrificing service quality or patient satisfaction.

2. Tangible Value Proposition to Sellers: The value proposition to sellers should extend beyond the promise of reducing administrative burdens. It should include clear, actionable strategies for enhancing practice, customer, and ultimately, the sellers' professional satisfaction and financial remuneration.

3. Value Creation Through Strategic Initiatives: Concrete, data-backed strategies for growth and value creation are non-negotiable. These strategies should be proven, replicable, and scalable, ensuring that each acquisition not only integrates seamlessly but also contributes to the overarching vision of the rollup.

4. Right to Win: Successful rollups articulate and execute a clear competitive strategy that differentiates them from the pack. This could be through superior technology adoption, a unique patient care model, or unparalleled provider support systems. The "right to win" is earned through distinct, sustainable advantages that are rigorously defended.

5. Best-in-Class Management Team: The complexity of managing rollups demands a leadership team with a blend of finance, M&A and operational expertise. The team's collective experiences and leadership capabilities are pivotal in navigating regulatory, financial, and clinical intricacies.

6. Engagement and Retention: Developing compensation models that align with sellers' aspirations and the financial health of the practice is crucial. These models should reward operational excellence, customer satisfaction, and ensure long-term alignment of interests.

7. Operational Excellence and Efficiency: A relentless focus on operational efficiency, through both process optimization and technology adoption, ensures that practices operate at ‘best in class’ efficiency and effectiveness, enhancing both customer experience and financial performance.

8. Rigorous Due Diligence: Growth for the sake of growth is a recipe for disaster. Each acquisition must be meticulously evaluated for strategic fit, potential for integration, and alignment with the overall vision of the rollup.

9. Sustainable Financial Structures: Financial sustainability requires a balanced approach to funding growth. Leverage should be used reasonably, with a clear understanding of the potential risks and a plan for managing those risks effectively.