The news has recently been dominated by the failure of Silicon Valley Bank, a financial institution whose clients disproportionately included venture capital-backed startup companies and founders. The bank’s management made irresponsible decisions regarding the investment of the bank’s deposits that limited the bank’s liquidity. When rumors of the state of the bank’s liquidity circulated within venture capital investment networks, it triggered a run on the bank as investors urged the companies that they had backed to withdraw their money.
While it may seem like an unrelated event to veterinary medicine, as seemingly most companies affected by SVB’s failure were tech companies and this author is not aware of any veterinary groups directly impacted, there are several concerning parallels to be drawn between the events of SVB’s failure and the behavior of many (particularly large, private equity-backed) veterinary groups that should serve as a point of caution and reflection.
A homogenous group of investors amplifies the risk of the “Institutional Imperative”.
In 1989 Warren Buffet defined a concept known as the “Institutional Imperative”, which is the tendency of executives to mindlessly imitate the behavior of their peers:
“I then thought that decent, intelligent and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so.”
If you pay too much attention to the behaviors of your competitors, you are prone to imitating their decisions – including their mistakes!
SVB was the perfect example. The bank primarily worked with customers who drew their funding from a relatively homogenous group of venture capital funds. The bank’s failure ultimately boils down to poor investment decisions of the bank’s management that led to a shortfall of liquidity, but the impact of those mistakes was amplified by having a cohort of customers who largely all think about risk and reward the same way and look to each other for cues – creating a “herd mentality”. This put SVB at a higher risk of a run than the average bank. Just as SVB’s depositors largely drew from a collection of venture capital funds, nearly all large veterinary groups (with AVP being a notable exception) draw their funding from traditional private equity firms. Most of these firms share similar investment strategies and philosophies on value-creation, and therefore are prone to imitating the decisions of their peer-competitors.
The Institutional Imperative in corporate veterinary medicine was most visible in three interconnected behaviors in recent years, particularly among large private-equity backed groups: Irrational valuation, irresponsible debt leverage, and inattention to practice-level risk.
Irrational Valuation: Veterinary clinics have very strong fundamentals compared to many other types of small businesses. However, regardless of quality and current market conditions, it is challenging to argue that valuations stretching into the “teens” of multiples of EBITDA for any standalone small businesses are prudent and justifiable. However, we saw that occur within veterinary medicine through the valuation bubble of 2019-22. This was fueled in part by institutional imperative: Groups looked to each other to validate the market (“surely they must be comfortable with the risk here to bid so much, so we should too”) and leaned heavily on an abundance of then-inexpensive debt while interest rates were low in order to perform leveraged buyouts at valuations that they probably would not have been willing or able to justify in absence of readily available debt at historically low interest rates.
This led to the second manifestation of the institutional imperative in veterinary corporate medicine:
Irresponsible debt leverage: While it is common and healthy for mergers and acquisitions companies to use at least some degree of leverage to support their equity, the dangers of excessive debt are known to most people regardless of their level of financial sophistication. Large companies typically have access to debt that amortizes over an extremely long period of time, meaning that nearly all the “cash cost” of their debt is interest rather than principal. When interest rates are very low (as they were over the last few years) that can create an incorrect and irresponsible perception of debt as being “free money”, especially if you’re trapped in an institutional imperative that views significant debt leverage as a tool that your competitors will take advantage of if you don’t. As a result, we saw several large veterinary groups take on large amounts of floating-rate debt which has since become significantly more expensive. That wouldn’t be too much of a problem in a scenario where the underlying businesses supporting that debt have been valued appropriately (as discussed above, they weren’t) and continue to perform well.
And so, all this led us to the final main stumbling block that several veterinary groups have run into challenges with:
Inattention to practice-level risk: When valuations rise and there are more buyers than sellers in the market, everyone becomes eager to find “diamonds in the rough”. At the peak of the recent veterinary practice market, many groups relaxed their acquisition criteria, performed less intensive due diligence, grew faster than they were prepared to support operationally, and failed to properly weigh individual practice risks such as keyperson risk (the idea that a business cannot thrive or potentially function at all if one or a few key people retire or leave for other reasons). This has resulted in groups acquiring practices that either were already struggling, unbeknownst to their buyers, or began to struggle as a direct result of acquisition because of subtracting keypersons (including exiting/retiring clinician-owners) and rolling the practices into a network that was operationally too overburdened by growth to adequately support them.
These three factors conspired into a perfect storm that has caused several private equity-backed veterinary corporations to experience cashflow problems due to overvaluing the clinics they bought, burdening themselves with large amounts of debt that grew in cost as interest rates have risen, and failing to build out robust operational support to ensure that the practices within their network thrive.
Consolidation reduces some risks but amplifies others.
While we’ve previously discussed some of the sometimes-overstated benefits of consolidation, reduction of risk is one of the major financial theses for why consolidation companies exist. The introduction of professional management, economies of scale, and shared resources all (at least theoretically) reduce the risk of small businesses that consolidate. While this is true, the Institutional Imperative introduces a new layer of risk in a consolidated industry – especially when that consolidation is driven by a relatively homogenous group of investors who are prone to imitation and circular reasoning.
At AVP, our decision not to be private equity-backed and to remain founder-operated is an intentional one. By retaining our autonomy, we can challenge the paradigms of traditional corporate veterinary medicine. This is reflected in our unique equal-financial-terms partnership structure, our selectivity in forming partnerships, and in clinical success driven by empowering our local partners as co-owners and leaders.
If you’re a practice owner interested in finding out more about opportunities to partner your practice with AVP, or a veterinarian interested in becoming a co-owner, please contact me at bill@associatedveterinarypartner.com
If you’re interested in becoming a team member at one of our partner practices, please reach out to our Director of People & Success, Tedd Trabert, at tedd@associatedveterinary.com.
Dr. Bill
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