Talking to veterinary practice owners and those who have recently sold their practices, you may hear the word “recapitalization” being bandied about in day-to-day conversation. What does this seven-syllable finance term really mean?
Recapitalization: What is it and how does it compare to a sale?
A recapitalization is when a company is sold from one private equity firm to another. Private equity firms and family offices own most, if not all, the corporate groups consolidating the veterinary industry, and they tend to hold investments for three to seven years. When a recapitalization happens, the management team leading the business usually stays in place, while the ownership and board turn over from one private equity firm to another. The major change that occurs in a recapitalization is in regard to the ‘capital structure’ or who owns the capital of the business – both its equity and its debt. Hence the term “recapitalization.” Let’s look at an example:
Veterinary Practice Partners (VPP), a corporate group, was founded with an investment from Deerfield Partners in 2011. After five years of growing the business, Deerfield Partners decided to sell VPP to Pamlico Capital. This is a recapitalization because the management team stayed the same, but the ‘owners’ of the capital changed.
A recapitalization is different from a business “sale.” With a sale, the buyer is typically a ‘strategic’ buyer, or a company in the same or similar industry. For instance, both Sage and Ethos, two specialty hospital consolidators, sold to NVA in 2022. These are sales and not recapitalizations since the change is occurring in the management team and not the capital structure. NVA’s management team will run the business, in addition to potentially bringing Sage and Ethos employees over to the NVA team as well. The current owners and lenders of NVA provided all the capital to buy the businesses, not a new PE firm. The owners of Sage and Ethos will receive a lot of money and will not own any of the business going forward.
In a sale, the integration process is more complex as two organizations are merging together. Difficult decisions are made regarding roles, responsibilities, and cost savings. In a recapitalization, changes happen at the board level, not within the management team, and the recapitalization process is fairly seamless to the day-to-day business team.
Why should veterinary practice owners care about recapitalizations?
Today, recapitalizations are more common than sales. Recapitalizations are opportunities for owners of the business (that’s you) to ‘cash out’ their ownership interest. Let’s review how deals are currently structured so you can better understand why (and when) recapitalizations matter.
Increased prices for veterinary clinics over the past five years have led corporate groups to offer some of their purchase price in shares of the company rather than cash. These shares are referred to as TopCo (“Top Company”) or Parent Company equity. They are not freely traded on the stock market because veterinary corporations are private companies. The opportunity for veterinarian shareholders to convert their shares into cash happens once every three to seven years when there is a recapitalization or a sale event. This is why there is so much chatter in the industry about these events and when they’re expected to happen.
Throughout 2021 and early 2022, there were several recapitalizations, including American Veterinary Group, United Veterinary Care, Alliance Animal Health, Veterinary Practice Partners, Amerivet, Rarebreed and others.
To date, almost every company that recapitalized has had significant upside for its shareholders, with practice owners gaining somewhere between good and phenomenal returns. When valuations go up, almost everyone makes money.
However, since mid-2022 the recapitalization market has been ‘frozen’ as the Federal Reserve has increased interest rates from close to 0% to 5%. The increase in rates has made it much more expensive for a private equity firm to pay a high valuation for an existing veterinary consolidator. The term ‘valuation’ means the purchase price multiple paid by buyers. In 2021, the multiple paid for those corporations that recapitalized were between 20x and 25x profit—record levels. If those multiples decline in the next few years, let’s say 17 to 19x profits, it will be more challenging for those shareholders to make the high returns seen historically when the value of each dollar of profit is receiving a lower multiple than in 2021.
With many practices being sold to corporate groups – close over twenty-five hundred hospitals between 2020 and 2022 – there is growing interest among veterinarians as to when their corporation will recapitalize so that they can ‘cash out’ on their TopCo shares. Through early 2022, recapitalizations led to great outcomes for most veterinarian shareholders but the process is in limbo right now with higher interest rates and the market effectively frozen until likely mid-2024 or later. Time will tell how the rest of this story is written!