Collateralized loan obligations (CLOs) are leveraged debt products similar to corporate bonds. These securities are usually divided up for investment into a variety of “tranches,” from the French word, “to split.” Each offering may consist of 100 to 300 issuers within a given investment tranche.
Senior tranches include first lien debt on different companies’ assets. More junior tranches (with added risk) also hold a variety of securities including bonds, loans, mortgages, and other forms of subprime debt. Maturity dates also vary. Buyers mostly include pension funds, the insurance industry, and the commercial banking industry.
A so-called “waterfall” is generated by cashflow distributions to the various CLO investment tranches on payment dates. This starts with the senior-most tranches, which have the highest claim. Then distributions flow down to a series of more junior rated debt of subprime CLOs.
Subordinate investment tranches have a higher risk of default and of delayed interest payment, and they hold a secondary or tertiary lien or no lien whatsoever. This riskier debt, termed “mezzanine financing,” generally only converts to equity once senior debt is paid off, in the event of default. As such, rating analysts give these investments lower grades.
Mezzanine financing may take the form of preferred stock or subordinated debt to the first lien debt obligations. Importantly, mezzanine capital is still senior to common stock. Common stock, or ownership in a company, is at the bottom of all the investment tranches. Those holding common stock are the last to be paid, if at all, in the event of default.
In any industry in which a company is highly leveraged with debt (five to 12 times the EBITDA, or earnings before interest taxes, depreciation, and amortization), an equity position with ownership of common stock usually has minimal company control.
Creditors will often govern the company through their appointed board members and their approval of management teams. Money that might go toward shareholder profit or company improvements is reallocated to pay debt obligations, and their creditors, which in reality beneficially own and command the company.
Company “ownership” on paper can be quite different from those entities that actually control the administration of a company. Further, the idealistic concept of a parent “holding company” (or limited liability company; LLC) operating at arm’s length from subordinate “operating companies” is almost always a myth.
By contrast, a less leveraged company with fewer debt obligations can maintain company control internally, such as small business dentistry. Profits may be remanded to shareholders in the form of dividends or to elevate salaries and benefits for valued employees. Profits may be used to generate cash reserves or buy back outstanding stock shares or reduce debt. Profits may also be used to facilitate company growth, hiring, market expansion, facility updates, customer service, or acquisition of other assets like cutting-edge dental equipment.
State Laws Against the Corporate Practice of Healthcare
Most states have statutes restricting the unlicensed corporate practice of healthcare. In fact, most employment contracts between doctors and management companies (in dentistry, dental service organizations; DSOs) have specific contract language that asserts the DSO will stay at arm’s length from clinical decisions. The veracity of these claims is often debatable, as civil courts are increasingly taking up these conflicts.
However, many larger DSOs are operating under highly leveraged debt and answerable to private equity companies and publicly traded Wall Street firms. Alleged violators of dental or medical practice statutes certainly point to management support firms. In many unfortunate situations, clinical decision-making may be distanced from the doctor/patient relationship.
Suits on Wall Street, private banking firms, and private equity companies may command subordinates in the execution of healthcare decisions. Those controlling leveraged debt of a DSO, with little to no healthcare training or license, demand interest payments on CLOs, as well as bonds issued.
Pressures may be applied to subordinates to do whatever it takes (cheap dental labs, mandated referrals to in-house specialists, understaffing and low salary for clinical support staff, production quotas, supplies of limited and poor quality, upselling of needless services to patients, misrepresentations to patients inclusive of discount dental plans, financing, and treatment plans) to generate production through dental care. Potentials for abuse are profoundly self-evident.
State Dental Boards
State dental boards are tasked with protecting the public. They hold authority over those licensed in their state to practice dentistry and related dental functionaries. Dental boards have the power to issue a license. They may also discipline a license holder and, in extreme situations, revoke a license.
Most state dental boards collaborate with their state’s attorney general office to investigate and prosecute the unlicensed practice of dentistry. This may come down to an unlicensed foreign national practicing dentistry from their garage, from a mobile trailer converted into a dental office, or out of a fishing tackle box from their vehicle.
The North Carolina State Board of Dental Examiners (NCSBDE) is the single state agency that actually requires a review of management agreements between doctors and DSOs. The NCSBDE will not turn a blind eye to the unlicensed practice of dentistry rendered from a fly-by-night low-end clinic or from a DSO that oversteps the statutes. This is in stark contrast to most states, which hypocritically ignore the unlicensed practice of dentistry by wealthier corporate syndicates.
Unenforced statutes relating to the corporate practice of dentistry have served to embolden DSO violators and their beneficial ownership in control of their leveraged debt. This includes business types on Wall Street and the private equity industry generally. Non-enforcement of statutes encourages unencumbered growth of lawlessness. CLOs are but a single tool by which control in the healthcare business may be facilitated by the unlicensed and unaccountable.
State registration of dental practice ownership for a DSO clinic may be held by a doctor or a group of doctors (in a professional corporation). Usually ownership is nominal by the doctors. Some are minority stakeholders and fully subordinate to the decisions of non-dentists. Other doctors are completely sham owners and truly control no dental company assets.
In some cases, dentists actually “own” the dental practices. Unfortunately, these practices are so encumbered by severe leveraged debt that creditors controlling debt products like CLOs have become beneficial owners and call the shots.
Dental regulatory boards that today have demonstrated an unwillingness and inability to enforce statutes against the corporate practice of healthcare need to step up. Regulatory boards must also enforce laws relating to beneficial ownership of clinical practices and, most importantly, their unlicensed control and management of those clinical practices.
Outside of North Carolina, no state dental governing board has even come close. The investor class is all too aware of this pitiful regulatory climate. Lack of investigation and enforcement represents opportunity for those consumed by greed.
Collateral
Theoretically, CLOs are backed by collateral. This is termed a “secured loan.” Borrowers place their assets at risk as a pre-condition to obtain a loan. The borrower has skin in the game.
Purchasers of a home usually place 20% cash into the venture as a down payment. Non-payment on the loan risks repossession by the lender, forfeiture of the down payment, and loss on any valuation appreciation. Those purchasing an auto usually do not receive full title until the loan is paid. If loan payments go unmet, the lender may repossess the asset of the vehicle.
Debt obligations of CLOs ideally should also be secured by collateral, especially in the higher grade first-lien tranches. This could take the form of company cash reserves, real estate, blue chip stocks and bonds, registered patents, company inventory, and signed business agreements such as distribution rights. Non-payment on debt obligations may result in debt-for-equity swaps, as creditors assume increasing company control. Creditors typically are not licensed doctors, and they detest seeing red ink on their balance sheets.
When a dental manufacturer acquires another manufacturer or embarks on a major expansion, it generally issues debt obligations (corporate bonds and other debt obligations) to facilitate the merger and acquisition (M&A) or growth. This debt often enters one or more collective groups of debt within a CLO tranche. Investors purchase these grouped obligations depending on their (or their analyst’s) evaluation of risks and potential for returns.
Collateral within newly merged dental companies may include real estate, cash reserves, unique and specialized dental supply testing and manufacturing equipment, distribution agreements, employment contracts with key personnel, registered manufacturing patents, unique trade secrets, and valuable brand recognition. All are viewed as assets.
Collateral Within the DSO Industry
I have reviewed many purchase and sales (P&S) agreements within the DSO industry. Some related to acquisition of a relative handful of practices. Others involved mergers of larger DSO entities.
I struggle to discover much real collateral in relation to the purchase price. Used office fixtures and dental equipment over a year old often seemed highly overvalued. The same could be said for dental leasehold improvements, especially on properties not owned by the seller. Existing dental supplies on hand may also receive an overinflated appraisal.
Manipulations of asset valuations deviate from what is typical in small business dentistry transactions. The asset of “goodwill” is generally assigned to the dental practice owner, a doctor, and a DSO is usually precluded from lawfully owning that practice.
Therefore, if a DSO or private equity firm beneficially owns the dental practice or practices, other alleged assets become overvalued for business appraisal. If the DSO were truly limiting its actions to nonclinical activities of support services, which is rare, workarounds on exaggerated asset valuations would not be required. The bogus pretense of doctor ownership needs to be maintained to circumvent state statutes.
Employment contracts often receive an outrageous P&S assignment of valuation. The P&S agreement often includes lengthy and exhaustive employment agreements with everyone from doctors, hygienists, and assistants to office personnel.
Making financial appraisals on employment contracts even more ludicrous are many states’ “right to work” laws, which may void such agreements. Some states also invalidate any contract enforcement on healthcare personnel related to a covenant not to compete. Even when a state will allow enforcement on a noncompete agreement for a healthcare provider, restrictions are far more limited than past years.
Further, unlike a dental manufacturer, there are no true proprietary trade secrets among clinical dentists that they cannot disclose per a contract agreement. Employment agreements that include nondisclosure of business proprietary secrets are an absurdity.
In fact, the ADA’s Principles of Ethics and Code of Professional Conduct states in Section 3.C: “Dentists have the obligation of making the results and benefits of their investigative efforts available to all when they are useful in safeguarding or promoting the health of the public.” Disclosure is ethically mandatory for clinical dentists to promote the public welfare.
Apparently, there are law firms working closely with their clients in the DSO industry that are expert in assigning deceptive and misrepresented valuations to employment contracts. Investors, analysts, and security regulators should investigate such practices as part of their due diligence responsibility.
Yet, P&S asset contracts within the DSO industry have exhaustive listings of employment agreements. Great effort is assigned into fabrication of a financial asset from this mirage. One wonders if investment managers understand that the DSO industry (not the dental manufacturing industry) may be nearly devoid of tangible collateral. DSO products held in CLOs, especially the junior tranches, may be backed by only hot air.
Conclusion
Some investors and analysts certainly understand why select healthcare investments may be suspect. In the first quarter of 2020, DSO junk bonds were punished in valuation. Employment contracts primarily represent a sham asset for the DSO industry, which may represent only one reason for debt obligation devaluation. The asset of “goodwill” may have minimal value for DSOs facing public high-profile lawsuits. Creditors may be highly resistant toward debt-for-equity swaps, especially for DSOs holding minimal assets and and still under massive debt loads.
Yet, the US Federal Reserve later decided to assign taxpayer funding into the subprime bond market subsequent to the COVID-19 pandemic. This action has at least temporarily propped up industries, like the DSO industry, some of which might have failed or restructured even without the coronavirus economic crisis.
Taxpayers may reasonably question why government policy has been redesigned to pump liquidity and public funding into suspect markets and industries that operate under flawed designs. Excessive leveraged debt represents a business model structured to suck the lifeblood out of a company, especially the healthcare industry. Delays in dissolution or restructuring of such corporations only serve to expand a potentially dangerous economic bubble. An uncomfortable economic correction today may prevent a catastrophic impending collapse.
Please note that commercial banks and insurance companies may be content accepting an annual 2.5% to 3% annual return on prime bond investments. By contrast, state pension funds, which have been severely underfunded and dubiously managed, often seek a 7% to 8% annual return.
Thus, a steep correction in today’s bond markets will not primarily impact commercial banks and insurance companies, but it will affect state worker retirees. Unlike the negative fallout in 2008, instead of falling upon companies deemed “too big to fail,” the next crash will primarily fall upon retired teachers, police officers, and career civil servants.
A future downturn in the DSO industry will not only impact employment for doctors, but it also will dramatically hinder patient access to care. Everyone risks a serious hit, from healthcare workers to investors, dental patients, retirees, and all of our nation’s citizens, who helped fund this wobbly house-of-cards.
If regulators at all levels continue in their failure of action, rest assured that the market will sort everything out. It always does. One might anticipate such an ensuing tsunami to be quite eventful, especially upon senior retirees and workers employed by companies leveraged through the private equity industry, which definitely includes healthcare workers.
Buckle up and hold on. We are about to embark on a wild rollercoaster ride.
Dr. Davis practices general dentistry in Santa Fe, NM. He assists as an expert witness in dental fraud and malpractice legal cases. He currently chairs the Santa Fe District Dental Society Peer-Review Committee and serves as a state dental association member to its house of delegates. He extensively writes and lectures on related matters. He may be reached at mwdavisdds@comcast.net or smilesofsantafe.com.
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