June 25, 2015
By: Michael W. Davis, DDS
Dr. Michael W. Davis maintains a private general practice in Santa Fe, NM. He chairs the Santa Fe District Dental Society Peer-Review Committee. Dr. Davis is active in dental care for disadvantaged citizens, and expert legal work. His publications and lectures are on ethical and whistleblower issues within the dental profession, as well as numbers of clinical research papers. He may be contacted at: MWDavisDDS@comcast.net 
Dr. Kevin Cain is an Assistant Professor of Management in the James M. Hull College of Business and guest lecturer in practice management in the College of Dental Medicine at Georgia Regents University. He teaches courses on strategy and entrepreneurship and does academic research in the fields of strategic management, organizational theory, and healthcare management. He also serves on a task force with the Georgia Dental Association and teaches continuing education courses focused on the business of dentistry. Additionally, he is a co-founder and board member of several companies serving the dental industry. He earned a PhD in Business Administration at the University of Georgia, an MBA from Wake Forest University and a BA in Economics from the University of North Carolina at Chapel Hill. He can be contacted at: kevin@kevinwcain.com.Introduction from Dr. Michael Davis-
Dr. Kevin Cain has an interesting and established history in study of the dental industry, and particularly dental service organizations (DSOs). He does research and has given lectures on the risks this business model presents against the public welfare and the integrity of the dental profession. Dr. Cain effectively counters the private equity spin of unlicensed corporate managers keeping at arm’s length from clinical decisions, within the doctor/patient relationship. He confronts DSO industry misrepresentations, of which there are many, head on.Interview
Dr. Davis: Dr. Cain, please relay the personal story of your mother, a practicing nurse, and the degradation of her once honored profession by corporate health care. How did that affect you personally and influence your fields of academic research?Dr. Cain: My mother has been a nurse within the same healthcare organization (and its predecessor hospitals) for 40 years. Since the late 1980s, she’s seen her role increasingly shift from being a caretaker to being part of a production line. The healthcare group she works for – mind you its a not-for-profit – sets performance benchmarks for pre- and post-operative care that her and her colleagues must meet. Additionally, her organization implemented EPIC Systems as its EMR provider last year and the time it takes to document patient care further decreases the quality of care she can provide patients.
She is no longer a happy nurse, and actually tried to dissuade my sister from majoring in nursing. At the center of her frustration with her company is its inability to treat patients as idiosyncratic. There are aspects of her job that, if not performed adequately, can jeopardize patient lives. However, her company pushes for efficiency and sets limits on the amount of time allocated for intake. When you generalize patients to the extent that her company has, and minimize the time nurses have to gather information about patients, it is inevitable that those nurses will miss something critical.
My mother’s frustrations with her organization have really shaped my perspective of the dental industry. She and many other healthcare professionals I have spoken with are disillusioned by the current state of their industry. The drive for growth and profitability in healthcare has superseded the drive for quality care, and I do not want to see the dental students I have the pleasure of interacting with here face the same disillusionment for their entire careers. It is imperative that the dental community protects the general dentist from becoming marginalized in the same manner as the primary care physician.
My research on the dental industry is driven, primarily, by the desire to help dentists remain clinically autonomous. In order for the dental profession to maintain its clinical autonomy, practitioners need to understand how institutional forces shape industries. In my field, we study institutional isomorphism – that organizations within an institutional environment look the same – because it helps explains how mimetic, coercive, and normative forces influence those organizations. There are currently no coercive (regulatory) forces preventing the DSO model from becoming the de facto dental model in the U.S., and there is very little normative pressure coming from private practice dentists to change that course.
With regards to mimetic forces, you have baby-boomers selling their practices to DSOs because a friend did and got more money than they would have in a private transition, and you have dental students – year after year – going to work for DSOs because they have been told that the high guaranteed salary is the quickest way to pay off student debt. Meanwhile, a few “business savvy” – or opportunistic – dentists are building their own DSOs and acquiring other practices because they see founders of the large DSOs driving twenty-five million dollar classic Ferraris and want in on that kind of wealth. These mimetic forces are shaping the industry, and the confluence of these forces is leading dentistry down a familiar path (i.e. optometry, pharmacy, primary care medicine).
Dr. Davis: We continually hear and read the misrepresentations from DSO private equity managers and their hired supporters that they keep at arm’s length from the practice of dentistry. Yet, we know they establish production quotas and bonuses upon employee dentists. Every doctor’s production metric is monitored on a daily basis. Each clinic’s bank account is swept clean, at least two to three times weekly. They determine clinic scheduling, staffing, as well as purchases for dental materials, dental laboratories, and dental equipment. State regulatory dental boards and even the Federal Trade Commission (FTC) seemingly have bought into these outlandish misrepresentations. (1) What private equity firm, whose sole responsibility is towards its shareholders and not patients, would not logically control every aspect of its business, inclusive of the practice of dentistry? (2) Why do we see so little regulatory enforcement for the unlicensed and unlawful practice of dentistry? Is it a matter of laziness, corruption, or some other factor?
Dr. Cain: The short answer is that private equity (PE) firms routinely leave control of their investments to the top management of those companies, but charge those managers with generating the best possible returns. The pressure of those expected financial returns can drive decision-making by managers of those companies, which is where you would see diffusion of pressure from top managers to the level of the organization at which revenues are generated. In the DSO model, that level is the dentist. To think that PE investments in the practice of dentistry, or the legal structure – where the DSO and the professional corporation that employs the dentists are connected only via a management service agreement (MSA) – keep DSO dentists immune to this pressure for financial returns is naïve. I would venture to guess that most dentists working for a DSO would tell you that they are not told to do certain procedures or pressured based on performance, but the psychology of seeing their production and their office’s production ranked against other associates and offices in the DSO probably provides enough of a catalyst to pressure driven, competitive individuals (generalizing here based on current crops of dental students) to alter treatment plans. That pressure might cause the best-intentioned dentists to compromise their training and ethics in order to climb rankings or achieve desired results (or bonuses). Because continuing education for DSO dentists is provided at corporate headquarters in some companies, treatment plans, labs, and materials used across the company probably begin looking very similar – and profitable – over time.
PE firms are in the business of creating value for its investors by increasing the values of portfolio companies over some period of time. They are typically formed with extendable ten-year agreements, with the goal being to yield profitable exits (sales) of investments in portfolio companies. Whether PE firms are subsidiaries of institutional investors (e.g. Ontario-based retirement systems, which are particularly fond of dentistry) or represent funds raised from multiple institutions and individuals (e.g. Leonard Green & Partners, an investor in Aspen Dental), they have a fiduciary duty to investors. Thus, top managers of PE portfolio companies are expected to generate optimal returns on investment, often at the expense of other measures of success or quality. Large institutional investors (e.g. OMERS, Ontario Teacher’s Pension Plan) can exert influence in most industries, given their assets, so why would they invest in an industry where someone not employed by the firm can has total control over its revenues? While they want you to believe that the DSO plays no part in clinical decision-making, their influence on hiring and firing decisions of the PC affords them the power necessary to influence clinical decisions.
I think we see little regulatory enforcement against unlicensed and unlawful practice of dentistry because the key constituent groups who should care most about the issue – private-practice dentists and the employee dentists of DSO affiliated PCs – are either highly fragmented have no orchestrated a campaign for reform or are reticent to push back for fear of risking their employment. DSOs, through ADSO, have well-orchestrated lobbying and political influence. The regulatory actions that we do see against DSOs are typically either patient or employee driven, when I think it is in the best interest of dentists to champion these changes so the negative perceptions of the DSOs do not affect the entire dental industry. The New York Attorney General’s sanctioning of Aspen Dental was a step in the right direction, but the required overhauling of the way it does business and the $450,000 fine is nothing for a company of its size.
Regulating the unlicensed and unlawful practice of dentistry perpetuated at DSOs
is going to be difficult because there are going to be contractual loopholes to work around any regulation that threatens the current model. To make an impact on this practice, dentists employed by a PC with a DSO agreement need to free to resist pressure from DSO employees without fear of termination by the PC. Maybe if the employed dentists were able to split the fines assessed to DSOs by blowing the whistle on this behavior, and those fines far exceeded $450,000, it would encourage those dentists under DSO MSAs to police the practice. This might also encourage the DSOs to change the way they operate and focus on support functions (e.g. marketing, patient retention, negotiations) rather than managing clinical production. These changes would not be ideal for PE investment, but would allow dentists to provide quality care and maintain high ethical standards. Dr. Davis: Dr. Cain, the DSO industry perpetually espouses their competitive marketplace advantage of “economy of scale”. While some of this may be true, especially for purchase of dental supplies, it’s not valid for the larger overhead expenses of any dental clinic; employee salaries and rent. In fact, layers of middle and senior management add to overhead costs. Could you please elaborate on the greatest advantage for the DSO industry, which is a variety of mechanisms of dodging lawful taxation and regulators’ failure to evenly enforce tax codes (big business vs. small business dentistry)? Could you further elaborate on what influence this may have on a local or state tax base? How may this negatively affect local small business dentistry, which plays by the rules and obeys local, state and federal tax codes?
Dr. Cain: Loopholes in corporate taxation are an interesting way of ensuring maximum profitability. For example, Delaware is a popular destination for incorporation because it does not tax royalty income of Delaware corporations on business conducted outside of the state. Companies pay their Delaware corporations royalties and deduct those payments from revenue earned in their state(s) of operation at no tax. This works as a mechanism to avoid what would be, otherwise, legitimate tax liabilities in those states.
Going a step further, some companies use offshore tax havens to limit their domestic tax liabilities. Their U.S.-based subsidiaries might engage in transactions, usually at some inflated price, with foreign subsidiaries in countries with favorable tax rates. For example, pharmaceutical companies have been moving their legal entities – not their management – to Ireland because corporate income tax rates are much lower than those in the U.S.
Theoretically, a corporation (e.g. a DSO) could avoid a five to eight percent state corporate income tax and reduce their national corporate income taxes by six or seven percent by using these loopholes. Obviously, these loopholes reduce the state and federal taxes bases significantly (billions in tax revenues per year), which likely increases the states’ demands on those small businesses that remain incorporated in-state. Operating a Delaware corporation may not make sense for a single practice, as it doubles reporting requirements and increases state fees (operating state and Delaware).
Dr. Davis: A number of dentists are selling their asset of their dental practice to DSOs. Usually, the sale is masked through use of sham nominee owner dentists subordinate to the DSO, or a group façade ownership in the form of a professional corporation (PC) also subordinate to the DSO. Much of the practice purchase price may be rendered via privately traded stock, not subject to Security and Exchange Commission (SEC) oversight. Please explain how these privately held stock values can be easily manipulated. How safe is a doctor’s retirement if largely funded by these stock shares? How safe is any entity’s pension fund money, if invested in a DSO?
Dr. Cain: DSOs probably structure their shareholder agreements in a way that most benefits the corporation. They likely used an experienced securities attorney to create a system through which the company dictates where, how, and at what value equities are transferred. These agreements may give the company, or its controlling entity, the first right of refusal for an individual’s or shares at a value set periodically by the company’s board of directors. Often, privately held companies will stipulate some sort of discount at which they will acquire shares from an investor in need of liquidity. As the SEC has no oversight of private securities, shareholder agreements outline the company’s reporting requirements and corporate governance is much different than in publicly traded companies. These reporting requirements can dictate the amount of transparency that private companies provide minority shareholders. Additionally, the Private Securities Litigation Reform Act (PSLRA) makes it extremely difficult to uncover fraud in private companies because the plaintiff shareholder must present evidence of fraud before discovery. So, shareholders’ abilities to determine the veracity of financial statements and valuations provided by private companies and their auditors can be extremely difficult.
How safe a doctor’s retirement is if they accept equity in a DSO in exchange for some or all of their practice, and how safe pension fund money is in DSO stock, depends on a number of factors, including the company’s debt (ratings or ratios), the characteristics of the equities offered, and the company’s operations.
Most of these DSOs are highly leveraged, and their debt (loans and bonds) is junk grade. Moody’s rated Aspen’s most recent Corporate Family Rating (CFR: if you lumped all of a company’s debt into one vehicle) was B2, while Heartland Dental’s CFR was an even lower B3. These junk ratings signify that the company’s debt is highly speculative (i.e. not investment grade).
If a company’s ability to repay its debts is questionable, as junk ratings suggest, then its equity should be considered even more risky. In the event of liquidation or reorganization under bankruptcy, debt-holders are paid before equity-holders. Additionally, these DSOs typically issue multiple classes of preferred stock and common stock (see the attached documents). Preferred shares are paid after debt but before common shares in the event of liquidation. Preferred shares are likely owned by founders, early employees, retirement and pension plans, and investment firms and pay a more fixed, more generous dividend than common shares. The dentists who accept shares as part of a practice purchase are likely getting the lowest class of the company’s common shares. That means that the dentist has the last claim to any remaining assets of the firm after all debts and other shareholder classes are satisfied. Additionally, these shares may have limited voting rights relative to other classes.
Dr. Davis: Dr. Cain, DSO employee dentists are subject to service agreements or service contracts, which largely place the DSO in control of dental clinics. Most of these service agreements stipulate a designated nominee owner, usually a duly licensed dentist. This doctor is subordinate to the DSO in contract language in that, in order to sell the asset of the dental practice(s) requires approval of the DSO. The contract also states the DSO will provide services into perpetuity. In effect, the DSO owns the dental practices, not a dentist owner of free will. How and why do state and federal regulators largely ignore such simple and fundamental readings of contract law?
Dr. Cain: I don’t know that state and federal regulators mean to ignore those contracts. I think the problem is likely tied to them being unaware of those contracts. Most dentists I have met are unaware of how DSOs structure their agreements, and many think that the dentists still maintains ownership over the practice’s equipment and employment contracts and that the DSO just provides back-end support. The dentists more knowledgeable of DSOs probably fall into three categories: 1) those employed by DSOs; 2) those who have a non-disclosure agreement based on their former employment with the DSO; or 3) those few who do not have the collective clout to enact changes at the state or federal level.
If these three categories represent those knowledgeable of DSOs, it should be no surprise that regulators are unaware of the structures of their contracts/agreements. In publicly traded DSO’s annual reports, they cite the risk of state or federal laws related to the ownership of dental practices (and their assets) changing as a key concern for the company (and its shareholders). They’re aware that regulators may catch wind of questionable legality of allowing non-dentists to control, through series of contracts, clinical decisions.
Dr. Davis: Because of our federal government’s fiscal policy of quantitative easing, we’ve seen interest rates at historically low rates for the past several years. There has been an abundance of cheap money available for big business private equity investors. We also realize all economic systems display periodic and episodic cycles. I don’t pretend an ability to predict economic cycles. However, history tells us that an uptick in interest rates is inevitable. Further, we might readily experience a sharp inflationary cycle. How might this influence the DSO industry, which is often financed and heavily leveraged on borrowed money? How might this affect individual and group investors of the DSO industry? Could we again experience a massive closure of DSO dental clinics and patient abandonment, as we saw with the bankruptcy of the interstate operation of AllCare Dental?
Dr. Cain: The first major effect of inflation on DSOs will likely be a slowing of their growth. As the DSOs cost of capital – both debt and equity – increases, their acquisitions effectively get more expensive. While their cost of debt increases for obvious reasons – higher interest rates across the board – their cost of equity will increase because debt becomes more appealing to investors at higher interest rates and equity has to produce higher returns than debt. With higher costs of capital, the additional economic value added by new acquisitions or de novo offices will decrease.
The second major effect of inflation on DSOs is a decrease in private equity’s interest in them. DSOs are extremely attractive investments so long as they can leverage low interest rates for growth. Not only have LIBOR (London Interbank Offer Rates) and U.S. Treasury Rates been low, but spreads (above LIBOR/UST) on junk bonds are at historically-low levels. Some DSOs with junk ratings have debt and credit facilities that cost 5.5% (interest), which is a pretty low bar to exceed in order to grow profitably. If that number doubles, the DSO’s ability to grow and achieve desirable profits decreases dramatically. Triple it, and DSO growth will slow to a trickle.
I will not go so far as to predict a massive closure of DSO dental clinics and patient abandonment occurring anytime soon, but I do think we will see industry consolidation slow as growth becomes more expensive for the DSOs. Great EBITDA (earnings before interest, taxes, depreciation and amortization) does not look so great when the I (interest) is high. Interest coverage is important for highly leveraged companies, and in 2013 Moody’s anticipated Heartland’s times interest earned (TIE) to be 7.0.
Conclusion
Dr. Davis: I sincerely appreciate the efforts of Dr. Cain for this interview. These questions are not the typical softballs we typically see in dental publications. Dr. Cain clearly qualifies as an expert on this subject. Our dental profession is hanging by a thinner thread than many realize, as is all of health care. The public is being manipulated and abused by interests outside the doctor/patient relationship and is patently unaware, which is exactly how the DSO industry wants it. Aiding and abetting abuses upon the public are elements within state and federal government, as well as groups within organized dentistry. The public interest demands full, open, and honest disclosures, in all matters relating to the doctor/patient relationship.
Dr. Cain: Thanks for having me, Dr. Davis. I think the exposure that you and Dentist The Menace are giving the misdeeds of both private and DSO-owned dental practices is a good way of weeding out the bad apples (dentists) so they do not spoil the bunch (profession). Speaking of bad apples, I wanted to mention that I ultimately think managerial hubris will lead to the demise of several DSOs.
Strategic management studies find evidence of significant relationships between managerial hubris and the propensity to acquire companies. Hubristic managers often feel that they have the “Midas Touch” such that they can create more value in each practice they acquire or open. They tend to generalize acquisitions, rather than treating them as idiosyncratic. Thus, they might make mistakes in unfamiliar local markets or alienate critical employees. Although these problems may arise and we are seeing increasing interest rates, the hubristic manager might think that their ability to extract value from acquired practices will always exceed the cost of growth. The hubristic manager will leverage the growth of his or her DSO until it is impossible to repay its debts.
Related Documents:
Heartland Dental 2006 SEC Form D
Heartland Dental 2008 SEC Form D
Heartland Dental 2008 SEC Form D (2)
Heartland Dental 2011 SEC Form D
