Will rising interest rates pump the brakes on dental consolidation?

Dental Private Equity Interest Rates

With the continued threat of additional rounds of an increasing Fed rate, one question being whispered around group dentistry and dental service organizations (DSOs) is what effect higher rates will have on private equity, the single biggest driver behind continuing dental consolidation.

The Federal Reserve began slowly raising the Fed rate back in December, 2015. This has run counter to what the European Central Bank did when they continued to cut rates, or Japan, currently enjoying historically low rates.

Debt Comes at a Cost

Since debt always comes at a cost, interest rates are always on the radar of private equity (PE) firms. While focusing on the bottom line, PE firms oftentimes use debt to leverage their investments and generate higher investor returns.

When profits are generated against debt, it has a direct relationship with the return that can be extracted from an asset. If rates go too high, there is not enough return to attract new investor dollars. The largest PE investors are institutional investors such as university endowments and pension funds.

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PE is ownership of an asset that is not publicly traded. Their mandate is to identify and invest in undervalued assets that have the potential to generate higher profitability. Fragmented industries like dental are a natural target for PE firms, as consolidation brings economies of scale, which drives higher returns.

Financial Cycle Investment Trends

When rates are low, institutional investors invest generously in PE firms, while during periods of higher interest rates, they are more likely to shift cash and new investments to fixed income and credit securities. As these investors become more skittish, fundraising for many PE firms becomes a challenge. Compounding this, during periods of high interest rates, the markets demonstrate less of an appetite for IPOs, which then causes asset valuations to decrease. As part of this chain reaction, desired exits become harder for many PE firms.

Not Everybody Loses

Cash-heavy PE firms take advantage of rising interest rates by seeking out new investments. If they accumulated cash when the debt was cheaper, they then deploy this cash to expand their portfolio at even cheaper valuations. This sometimes includes the bolt-on of industry-specific platform companies of other PE firms that are many times purchased at a discount.

DSO News caught up with our friends at Dykema, a leading national DSO law firm, to learn about what they’re seeing on the ground:

“Our PE clients are naturally cautious about eventually higher interest rates but they also recognize that higher rates (up to a point) signal a healthier economy not dependent on the “sugar rush” of low interest rates.”

Eric White, Dykema Member and part of the firm’s Corporate Finance Practice Group and Dental Service Organizations Industry Group

With sensitivity to interest rates, it is natural to be curious about the effect of rising rates may have during a period of economic uncertainty and what it will do to the investor dollars currently pouring into the dental industry.

Thankfully, there is nothing to worry about. For now, at least.