Value Creation Plan: Arbitrage vs Margin

26 min
Season 1
Listen directly on:

In this episode, Dr. Ivan Zak and Dr. William Griffin from Veterinary Integration Solutions talk about the critical components of a value creation plan.

Topics Discussed:

  • Value Creation Plan: Basic business plan used to effectively guide decisions
  • Consolidator: Creates value for shareholder and practice seller within timeframe
  • Reasons to Invest: Vision, mission, and values to start a consolidation
  • Value Creation Plan/Strategy – Fundamental Components:
    – Arbitrage (acquisition and merger of small, independent practices)
    – Operations (what you can, should, and not do after acquiring a practice)
  • Margin Expansion: Europe’s data, systems, processes cleaner than U.S. market
  • COVID vs. Client Behavior: Human-animal bond continues to get stronger
  • Healthcare Capacity: Reduce stress and strain by implementing changes
  • Diligence: Create value by partnering and aligning with people and culture

Speakers

Dr. Ivan Zak has earned multiple accreditations in veterinary medicine. After graduating, he worked in 35 veterinary hospitals across Canada, where he was inspired to create Smart Flow, a first-in-the-industry workflow optimization system. Smart Flow was subsequently acquired by Fortune 500 company IDEXX, where he became General Manager of the Software division. After consulting 500+ practices worldwide on workflow optimization, he decided it was time for a new adventure. Dr. Ivan has a holistic view of the whole veterinary business market and he’s making his next step the creation of a more cohesive, unified platform that will ultimately benefit the veterinary professionals.

Transcript

Dr. Ivan Zak

You’re listening to Consolidate that! Podcast.
Hi, everybody and this is Consolidate that! Podcast. We’re having a first season and the first episode recorded today. We’re going to talk about the very basics of a consolidation. We will talk about value creation plans and what is that.
Bill, thank you for joining me today, how’s your day going?

William J. Griffin

It’s going great, Ivan. This is a pretty exciting topic to talk about.

Dr. Ivan Zak

Absolutely. This is something that when we connect with consolidators, we have to establish from the very beginning, and the value creation plan is something foundational that they need to have and understand, and will articulate to their investors in the clinic.
Bill, why don’t you expand on what is a value creation plan in your understanding and how would you explain it to our listeners?

William J. Griffin

It’s the most basic, it’s a business plan but it’s a business plan that’s directed towards investors as well as to potential practice sellers. It’s focused on how the consolidator is going to create value for both the shareholder as well as for the practice seller within a given timeframe. It is a pretty well-defined plan, and it is focused on value. Understanding those two pieces is critical to then understanding how that value creation plan can effectively be used to guide all decisions, from acquisitions, to branding, to operations, and ultimately to an exit.

Dr. Ivan Zak

Awesome. Where would one use that? Let’s say I’m a brand new consolidator and I created this business plan or value creation, I assume it’s not going to be a 50-pager, it’s probably something more concise and easier pitched and articulated, where would the new consolidator use that practically?

William J. Griffin

First, it starts with a vision and a plan. It’s used essentially to garner interest and momentum to go from the concept of, hey, I think I can start a consolidator to go to potential investors whether that’s friends and family, or whether that’s private equity, high net worth individuals. Whatever that plan is to fund, this basically is the foundation for aligning people, aligning the vision, and then also attracting some of the core founders that are going to be instrumental to build this enterprise.

Dr. Ivan Zak

All right. If I’m understanding you correctly, that’s basically something that I would go and say, hey, Bill, I want to start a consolidation and you heard about this in the industry and it’s attractive to investors, but I will tell you this is why and this is how we’re going to make money, this is why I want you to invest into this business, and then it should basically explain how the value will be created when implemented.

William J. Griffin

Exactly. It’s your vision, it’s your mission, to some extent, it may pull values, if that’s an element of what you’re going to use to differentiate yourself, the field is crowded and well-crafted. It truly can be a template for the next three to five years as you navigate the ups and downs of consolidation.

Dr. Ivan Zak

Awesome. I think that you’re forgetting one more F. In my experience building startups, there’s friends, family, and fools that believe in your new initiative but I think that with the opportunity in veterinary space, there’s probably no fools in that because it’s rampant and there is definitely an opportunity.
What are the components of a value creation plan? What are the most typical things that people would include that it becomes so exciting that people would just start investing money into veterinary consolidation?

William J. Griffin

The fundamental component is the arbitrage which is the acquisition of small, independent practices to become part of a larger enterprise. The first three to five practices would get a consolidator off the ground. Then once they get to 10, to 20, to 30, to 50, then they start scaling and that’s where the value is created. It’s typically around EBITDA. EBITDA is the driving factor when it comes to wealth creation for those that are invested and those that are partners. The fundamental piece is practice acquisitions. Without successfully navigating that part, there is no other opportunity to create wealth.

Dr. Ivan Zak

Bill, if you can maybe break it down a little further to me. If I spent money buying practices, now I have the business that is functioning and then I bunch them together, how does an investor get their money? Because basically, we spent the money on buying clinics, where’s the return on investment in this?

William J. Griffin

If you’re an early investor, the expectation in the market is that you’re going to get at least three times your initial investment within a three to five-year window. That could be as high as five or six but as far as the minimum, the expectation is the 3X return and that’s pretty healthy. While there are better investments that can be had, the risk is relatively low when it comes to veterinary consolidation. That always is not the case, there’s been other verticals that have been consolidated, human dentistry is one that did not have a return and had a fair amount of risk.

Dr. Ivan Zak

Wow. Okay, that is the arbitrage. What are the other components of the value creation plan?

William J. Griffin

The arbitrage piece is M and A, it’s mergers and acquisitions that most of the players in the space have a fair amount of experience with and it could be in different verticals, it could just simply be in buying and operating businesses.
The second phase is the more challenging one and that is the operations. Once we’ve made the pitch, closed the deal, now we have to operate this practice. This is where the value creation plan is critical and this is where you get into the what can you do, what should you do, and what should you not do once you acquire a practice.
And it depends on your operating model. Some consolidators simply are going to buy really great practices, they’re going to create value for their shareholders to the arbitrage, and they’re going to do very little with them post-acquisition, the goal is to not break them. Others will take the other end of the spectrum and try to improve margin, same store performance. Whichever model they choose, that needs to be fully baked into the value creation plan.

Dr. Ivan Zak

We have seen a lot in the past at least year and a half working together is that because arbitrage is pretty straightforward and most people that go into consolidation, they know how to buy practices and then the return on investment is they increase the multiple of the EBITDA after they consolidate them and then, for example, resell it to a bigger consolidator. But the second part is becoming challenging more and more because that’s harder to do, is that correct?

William J. Griffin

Yeah, it’s harder on a lot of levels. The veterinary space is about 20%, 22% consolidated, so there’s still a lot of opportunity. However, the portion that’s already consolidated contains a lot of the high-performing practices. What’s out there are smaller practices as well as practices that may have some concern for a consolidator.
The opportunity for the arbitrage piece still exists but what’s becoming more important now is the margin expansion once you acquire these practices. The model for how to do that basically doesn’t exist, and there’s a lot of reasons for it. It’s the time frame, the private equities are typically looking for return on the investment within three to five years. It is very difficult to buy practices, integrate them, stabilize them, and then improve them to any significant extent during that small time window realizing that these consolidators themselves are brand new entities as well. They’re going through all of the growth phases that any business does while acquiring 100 to 200 practices, even 300 practices in some cases during that three to five-year window.

Dr. Ivan Zak

You mentioned 20% plus and that’s what we’re seeing on the North American market but you and I explored a little bit the European market and it sounds like it’s now north of 60%. It sounds like they patterned their changes right now because definitely the best practices are already sold to consolidation and now they’re confusing more on the other part, is that correct?

William J. Griffin

Yeah, it is. It was really exciting to take a look at European market because it is so different, it’s fundamentally different in many, many ways. To your point, since 60% of all practices have been consolidated, the only real opportunity to create value is through margin expansion. When we looked into it, one of the things that we saw is that systems, processes, and data were pretty clean in these consolidators. Whereas in the US market, that doesn’t exist, everything is fragmented. Again, our perspective is just because of the immaturity of the US market compared to the maturity of the European market, but it does offer us a direction of what the future of the US market could look like.

Dr. Ivan Zak

What is happening—and what I’m hearing you’re saying—is that right now is still the gold rush of let’s buy the practices pretty quickly. I heard this and I’m using this and stealing it shamelessly but yesterday, we had an entry on the other podcast where someone said that veterinary medicine is immune to COVID. I love that because it seems like we’re actually growing despite the pandemic, and then right now a lot of people with all the market volatility have taken money off the markets and now reinvesting in something progressive through COVID, and veterinary medicine seems to be one of those areas.

William J. Griffin

There’s no doubt and that’s been seen through multiple recessions. 2008, I, at that point, had just built a new multimillion dollar hospital and so this emergency referral hospital was faced with the reality that there was no idea whether that was going to basically close because of the recession. While we did see a decrease in volume and we did see a change in consumer or client behavior, it was nominal, it really was that human-animal bond that basically continued to bring clients in the door, and they did what they could. I think that’s what we’re going to continue to see and that bond is only getting stronger. COVID, again it’s a worldwide catastrophe, but on the veterinary side, it just shows the importance of pets to people and families.

Dr. Ivan Zak

There’s couple other factors that we observed. One of them is that people are spending more time at home with their family and there’s no pets in the shelters anymore, all the pets are actually adopted, that’s what I’m hearing from colleagues in the shelters which is amazing. This is great though, so we don’t have all those dogs in there. But the other side of it is that not only there’s more pet ownership through pandemic, but also now people spend more time at home with their pets. And then now those symptoms that they were not observing at home while they were at work, now they’re more prominent to them and they’re worried earlier. Being an emergency veterinarian, your most common, doc, do you think it’s okay that my dog is vomiting blood for three days is probably not a thing anymore and people come into the hospital a little earlier and that I think is another driver for it.

William J. Griffin

It certainly is without a doubt, there’s a dark side to this, and it’s the capacity of these healthcare teams. We’re seeing some of the stress and strain that that is creating, and there already were fractures.
The positive to this of course is there are no strays in shelters and that the human-animal bond is I think stronger than ever. But I also have seen that veterinary practices are more open to change, and veterinary consolidators are taking that opportunity to implement change across their organization that otherwise I think would’ve been very difficult to get traction. What I’m talking about are new technologies like telemedicine, new ways of doing business when it comes to leveraging the healthcare team, the support staff. Those are really fundamental differences in the way that veterinarians have traditionally practiced, this is basically accelerating what consolidators were asking for.

Dr. Ivan Zak

I’m glad that you mentioned change because what we’ve seen with the consolidator practices is that the value creation plan that they want to implement is thrown at these clinics immediately after acquisition. And then when they are not change-ready or when the consolidators think that, okay, these are the changes that we need to do in order to achieve our value creation, they forget that there had just been a significant change in the practice, they changed ownership.
That is one of those hardest things on the value creation plan on the operational efficiency side because now you have people who led the team just stressed, the leader changed, the leader was disempowered because they were thinking that they were getting paid, their career established, and then all of a sudden they are employee in the facility where they were in charge. That’s where we see all these problems with people leading the practices where they should be considerably improving the margin, that’s one of those stressors that we see.

William J. Griffin

You’re touching on I think what our next podcast is going to be about which is the do’s and don’ts of consolidation. One of the things that I think that there’s a bit of a blind spot is the amount of change that a practice goes through post-acquisition. A lot of that is concentrated on the management team or the leadership team of the practice.
It can be a great experience if there’s alignment between the culture of the consolidator, and the practice, and the value creation plan is not tone deaf to the challenges of the day-to-day practice operations. I’ve seen great experiences across the board. I’ve also seen pretty bad experiences when there was lack of alignment, when there were foundational weak spots in the practice prior to acquisition. Like anything else, if you are faced with a stressor and that you don’t have a strong foundation, you’re more likely to have significant negative consequences as a result.
It goes back to the value creation plan of what type of practices are you acquiring? Are you looking at culture part of your diligence or is it just financial? Do you understand how the practice that you’re looking to buy, how they create value for their clients? If the way that they create value is different than the way that you create value, you probably shouldn’t partner with them. I’m seeing more and more consolidators doing a deeper dive on diligence when it comes to people, culture, alignment because I think what they’re finding is that it’s very difficult to replace employees when they leave the practice post-acquisition. Revenue drops very quickly if you lost some key people in the practice, particularly doctors of course, and that’s a risk that consolidators realize that they have to minimize.

Dr. Ivan Zak

That also depends on the strategy. Some consolidators actually prefer that as we’ve seen and their strategy is to replace the owner as soon as possible, but those are more those that replace everything, they replace the systems, the data, the processes, and they do just a complete turnover, and those that rely on the existing owner to continuously be incentivized to drive the value creation plan, those that are suffering if you implement too much change early in the game.

William J. Griffin

That’s a good point. Those groups that come in and change everything, they grow organically, they tend to be slow growers, and they may acquire two or three practices a year versus two to three practices a month, or four practices a month, or six practices a month.
Again, it goes back to the value creation plan. Are you creating value through arbitrage and acquisitions? If so, the post-acquisition change has to be relatively light. Are you creating value through performance enhancements? Then you can buy practices that are poorly performing, transform them, and create value that way, but it is a much slower process.

Dr. Ivan Zak

There’s the concept that we’ve been toying around and talking to consolidators, the difference between this value creation strategy and value creation plan. Can you parse those two for the listeners and open a discussion on that?

William J. Griffin

That was an a-ha moment that we had, I don’t exactly remember when but typically it’s talked about as a plan and a plan traditionally is a well-defined structure to achieve a particular goal.
When it comes to the acquisition side, it truly is typically a well-defined plan. When it comes to the operation side, it is traditionally more of a strategy. It usually goes like we’re going to increase margin by lowering the cost of drugs and medical supplies, we’re going to improve labor management, we’re going to do a better job with marketing. Those are strategic at best, probably more aspirational, they’re certainly not a plan, they’re not tactical. What happens is while they sound good and they look great on a deck, if you go in and try to improve your cost because, hey, I think we can buy drugs at a lower cost, there’s a significant impact on the practice as well as the enterprise if you want to do that at scale. If you’re doing that in one or two practices, it’s not that hard.
Over 50, or 100, or 200, you need to have a true plan, the right systems, the right processes, and you have needed to communicate to the practices prior to acquisition that this was part of the way that you are going to create value. It can’t be nothing will change, and then all of a sudden, I have to change all the drugs and medical supplies that my staff uses and my clients expect.

Dr. Ivan Zak

That’s a very important point that we observed is that once you have that in your deck—and that again dips into our next topic next week—but after you articulated what it is, you need to have a subject matter expert that can create a process around how you’re going to achieve that because if we’re just going to say we’re going to have better marketing, then how do you implement better marketing? How do you rule it out? What is the time of return now with your investment into this process? Is it within the window of your private equity fund? Is it within that three to five-year?
If you start improving let’s say search engine optimization, that’s a long process. If you start implementing these across all the hospitals, it can cost you a couple grand a month if you use an external vendor. Is it going to give you return on investment fast enough? Aside from just having a strategy, there needs to be a well-articulated plan and put in perspective through a very precise project and program planning as you acquire practice, determine which one needs that change, and then that change implemented and understand when it’s finished, and then measure it as well. That’s the art I think of converting the value creation strategy into a value creation plan.

William J. Griffin

I would agree. Marketing is challenging. Marketing and veterinary medicine is local, and centralizing marketing is often part of what consolidators do, and that alone creates significant friction.
It’s really understanding the nuances of the business and what drives a performance at the practice level, and then the consolidator also having an understanding of what is their capacity, how did they create value? Young consolidators that have a plan to grow rapidly create most of their value through the arbitrage. As they mature, and they become more stable businesses, and they understand their market, and they can target practices better, then the opportunity I think is much greater to improve practice performance.

Dr. Ivan Zak

I wanted to summarize what we’ve talked about and break down the two because I was toying with the math on this sheet of paper here. To break down the two—Bill, correct me if I’m wrong in my thinking—if I’m approaching the practice that has a revenue of about $1 million. We’ll just use square numbers to articulate what we’re talking about. Then if the EBITDA of that practice is 15%, essentially, you can buy that practice now at about 10X, let’s say. You have 150,000 of EBITDA, and then if you buy it at 10X, this practice would cost you to buy $1.5 million, so you invest that amount of money.
Then if you continue consolidating, there’s been exits recently that we’ve seen in the last two, three years that were easily in the area of 20X. If you didn’t improve the second part of the value creation plan, you just took a $1.5 million clinic, and then you sold it at 20X and you sold it for $3 million, that easily doubles the price of that practice. That’s just the first part, that’s the arbitrage.
But the second part opportunity is improving the margin. If you’ll expand the 15%—again using square numbers—let’s say to 20%, now all of a sudden, you can sell the practice at 20X, 20%, and then we come up to about $4 million. In two, three years after consolidating a number of practices, you can buy practices at $1.5 million and sell at $4 million. Is that the two to three term that you’re talking about, Bill? Was I correct there in my calculation?

William J. Griffin

I’m not checking your math.

Dr. Ivan Zak

I was looking at the paper, I was cheating.

William J. Griffin

Let me dissect that for a second. You’re correct in just about everything and I think the point to drive home is that, yes, there are a lot of practices out there that have a 15% EBITDA and those are opportunity practices because there’s an opportunity to bring them up to a 20% EBITDA. A 20% EBITDA for any practice is certainly reasonable, but the majority of independently-owned practices are under 20%.

Dr. Ivan Zak

What’s the maximum that you’ve seen? What’s the maximum that you’ve seen a practice fully-functioning, full steam?

William J. Griffin

That’s another good question. I’ve seen them in the mid-30s, but that’s another podcast. It is possible, the question is, is it sustainable? The other question is if you’re a consolidator, should you buy one of those practices, because they have nowhere to go but down typically.
Back to your point though, the driving force is exactly what you said. Look, if I buy it at 15% and I improve it to 20, and then I get 20X on my enterprise EBITDA, I just doubled my practice level EBITDA. You could see from a value creation private equity shareholder point-of-view why there’s so much desire and energy to not only acquire but then also to improve performance.
The math is intoxicating when you start looking at it, and it’s that intoxicant of EBITDA that often drives the energy behind implementing change that may not necessarily be a positive change across the organization at a given timeframe. Doesn’t mean that that change and opportunity can’t be implemented, just means that the timing and the capacity needs to be understood before it is implemented.

Dr. Ivan Zak

Awesome. I’ll summarize that. This was an episode on value creation plan. We talked about two different types of value creation, arbitrage versus margin expansion. We talked about which one is faster and potentially easier, and then the importance of having a value creation strategy and then to plan how you will deliver that to the practices. There’s a significant opportunity in the veterinary market, but there’s an art to converting your strategy into a plan.
That will conclude our first episode. Next time, we’re going to talk about the do’s and don’ts of the consolidation at different maturity levels.

William J. Griffin

Bill, thank you for your participation. I’ll see you next week.
Thank you so much for listening to the Consolidate That Podcast. If you want to hear about our new episodes, please find us on any podcast platform. Also, you can learn more about us on our website at vertintegrations.com. Stay Safe.