Chris and Rob Michalik - Twin Tackle of Private Equity at Kinderhook (EP.416)

25:08When you want to back management teams, how do you go about the assessment? 75, 70 % of the time when we buy a company, we're putting in one of our operating partners as the CEO. The other 25, 30%, we're back in the incumbent management team. We will put our existing operating partners onto the board. We want to make sure there's that continuity and that training and that stability. And one of the great successes that we have had is that we have been able to keep our operating partners with us over multiple deals, multiple companies, multiple funds. Over the course of our 20 years and eight funds that we've been doing this, we started inviting our operating partners who had some success to invest in our fund.

25:46If you look, the last two funds, operating partners invested$100 million. They're paying full fees, full carry. They believe in what we do, and they love being a part of our organization. So this is a real strategic asset, and I think a real difference maker in how we drive success. When you look through that last lens of helping grow the businesses, What is it that you do that's different from other private equity firms? Rob will say all the time, it's unleashing the American dream for a lot of these people. This comes back to the focus on growth, low leverage going in. We meet with and talk to the teams about where they want to go and what the opportunities are.

26:23And then we ensure that they're capitalized to execute on those opportunities. A lot of it is consolidation-led growth, specifically in the environmental and industrial services arenas that I invest in. In the healthcare services side, it's new locations, new facilities, new offices, and new teams. So there's a J-curve effect of investing in those types of facilities and growing those markets. But it's the orientation toward growth and driving returns through growth as opposed to financial engineering. And the families that built companies that get to a point in a stage where they know they could grow, they know they could maybe buy a competitor, but they don't want to take that risk on their own balance sheet, we become great partners for them to allow them to recap their business, put money in the bank, secure the trust in the family and retirement, and take risk again to build and grow their businesses.

27:16So that's really been the model of success for us. What do you think works in making investment decisions when you clearly have a partnership from birth that's not going away anytime soon? Ultimately, you can't blame the other person one, things don't go well. And at Kinderhook, I believe one of the biggest reasons we've been successful and had the stability of our team, we've done bad deals. We're not immune from bad deals. It's because we have done the bad deal, i.e. the firm, and it's our responsibility to fix it. If there's a pattern of laziness, a pattern of lack of concern, a pattern of just poor decision making over years, we have fired some people over the 20 years that we've been doing this.

27:57but from a culture of accountability, hey, we're accountable for the deals. And when the investment committee, which is Tom, Rob, and Chris, but it's the firm, because we all have ownership, we all have carry, we make that investment, we own it. And it's our job to make sure we have the best outcome, we grow the business. And I think that mentality of shared responsibility, shared accountability, that Rob and I, that's our life. Like it or not, judge it or not, people look at us as one. It's the circus show. So I think those are some of the strengths that come from the circus. We're going to take a quick break in the action to tell you about SRS Aquium.

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29:21Learn more at srsaquium.com. That's S-R-S-A-C-Q-U-I-O-M.com. And now, back to the show. So I'd love to dive into one of the examples of the businesses. I know, Chris, there's a lot of buzz, not positive buzz, about the healthcare sector and private equity. And before we jump into this recent interesting example, I'd love to just get your impression of all this noise. I appreciate you asking the question. It's unfortunate, but our healthcare system in our country is a very complicated one. And I've been investing in healthcare for over 25 years now. I made some early investments in hospice care in 1998, was introduced to government pay.

30:07As you look at what's happened over the last 30 years, over 55 to 60 % of all healthcare in the United States is paid for by federal and state programs. That's a result of both demographics and the fact that politicians will continue to support healthcare in our country and lead to drug development. So that's the first overlay I think you have to understand. What has happened as part of that is that you've had consolidation. And because the margins are very low in healthcare services, I think people forget that hospitals don't make a lot of money. They've never made a lot of money. HMOs don't make a lot of money.

30:41They've never made a lot of money. Doctors used to make a lot of money. In the 70s and 80s, the doctor was the pillar of the community. He had the nicest house, had the nicest car, went to the country club. Today, doctors work very hard and make more of a middle-income salary. And the burden on them to deliver healthcare has increased exponentially because of the paperwork, because of the bureaucracy, because of the cost, and because of the fact that many of them now step out of school with very high debt. So there's all these factors that go into healthcare in the United States that are very complicated, and it's not a great system today.

31:17So despite the fact that even after the passage of the Affordable Care Act, most people have access to health insurance, it does not mean that they have access to health care. It's become popular to look for someone to blame. And unfortunately, I think that blame has went an easy target is private equity because they want to look to someone and maybe say, oh, they're rich, their incentives aren't aligned with the delivery of good health care. that's a much maligned perspective. I'm never going to say there's no bad actors, but by and large, 99 % of private equity professionals in healthcare are looking to invest in businesses, grow those businesses, provide opportunity to the caregivers and the patients so they have broader access to healthcare.

32:00What we do in healthcare service investing is look at either commercial pay or government programs and say, how do we participate in these programs to create efficiency and to drive growth such that there's more access for patients. If you just take providers over the last three or four years, there's been a rapid consolidation of primary care as well as especially providers of healthcare services, and it's been done by private equity. But it wasn't led by private equity. People forget that the big buyer of providers is health systems. The health systems have consolidated. Hospitals are mostly not-for-profits, but they need to put people in beds.

32:40Their asset is a bed. They get reimbursed to have people in that bed. They're like a hotel or an airplane. If they're empty, no money's coming in, that's not very good for their business. So to make sure that they can control the volume of patients, they try to buy providers. A lot of providers don't like to be managed. Doctors don't want to be managed by anyone. They have a mission and a purpose, which is to care for patients. In their perfect world, I think doctors will say, I don't want to be owned by a hospital system. I don't want to be owned by a HMO, a health maintenance organization, and I don't want to be owned by private equity.

33:10I want to be either an individual operator or a partner with my fellow doctors. Unfortunately, the dynamics in the market have changed that that's very hard to do today. One, as I stated, doctors come out of school with very high debt load in almost all cases. They then spend four years in a residency and then especially training where they make really no money, it's indentured servitude. They come out and they need to get a job and they can't hang a shingle and put on a lease because they're structurally bankrupt the day they walk out of medical school. Number two is the burden to provide care is not just about seeing a patient.

33:45After I'm done doing that, I need to now put all that into a system. And government mandated electronic medical records from patient files a long time ago. These systems still don't talk to each other in most cases. Long story short, that doctor is burdened by paperwork. The cost of their rents going up, the cost of their staff is going up. now they need to collect money to have it be paid for. And in a few markets, people pay for healthcare with cash, but in most markets, you collect from insurance. As much as we as individuals want to complain about insurance not paying, doctors complain more about insurance than patients.

34:18Because you have a runny nose and you come in and see your doctor and you think that doctor visit is$120, but that doctor is being reimbursed$20 by UnitedHealthcare to tell you you have a runny nose. The doctor can't make a living doing that. So he or she needs to scale their business and put in back office billing people. So now imagine as an individual operator, that's not realistic. So now they have to be part of a group or part of a system. And that's where private equity comes in. When a doctor sells to a hospital system, an HMO, or to private equity, they're in a free market system. They're doing what they think is in their best interest to manage the best for their patients.

34:54And they're focused on patient care. What we do, and our private equity brethren as well, is that we provide these doctors now an opportunity to do what they've been trained and desire to do, deliver high-quality healthcare by bringing in infrastructure, software support, EMR, billing systems, leverage, and collections with contracting, bringing in contracts. If you think about the big three forces of healthcare, it's these HMOs negotiating to keep rates down and provide access. Hospitals are negotiating to bring in as many patients as they can and get the highest prices they can to cover their fixed cost in their own minds.

35:31And then doctors who are the delivery of care, who are the weakest member in that three-person negotiation. And we help the doctors. We get better contracting with United or with the hospital system, which provides more access, lower cost, and better healthcare. So no system is perfect. Everyone behaves according to their incentives. I could spend a long time talking about the poor incentives that are created by our healthcare system, mostly created by government programs. But ultimately, private equity is part of the solution. And we help invest in and bring additional resources to communities, to low income neighborhoods and the like.

36:11As you describe that value change, the system's not great. Each of these three important buckets aren't making a lot of money. How do you think strategically about where you can invest so that you can make attractive returns in a system that is fairly unwieldy? The market of today is really around providers because it gets back to there aren't enough doctors to service all the patients that now have access to healthcare. So introducing technology to help scale what a doctor can do by freeing up their time to focus on patients as opposed to paperwork as part of what leverages cost, as well as what people call mid-levels.

36:49So nurse practitioners, PAs, physician assistants, people that are not trained to hold a medical degree, but have training to deliver basic healthcare needs and can serve patients so that doctors can stratify their delivery of healthcare by hiring mid-levels, and they can see the sickest patients in triage. And bringing those resources and scaling doctors is a great opportunity. And that's something that you see smart practices and private equity, that innovation, understanding how to work with the payers to make that billable, et cetera, is all very important. People want healthcare, but they don't always think about that it has to be paid for.

37:26And the billing system and the payment system is a big part of it. Another big area of investment is in revenue cycle management and the collection system around healthcare. I'd love to dive in a little bit on your most recent acquisition, which has been one of the more colorful names in the headlines. Stuart, why don't you walk me through this opportunity, how it came to pass? Stuart Healthcare was a company acquired by a private equity firm in 2010 or 12 called Cerberus. They acquired a group of struggling hospitals and through a series of acquisitions over a 10 or 12-year period, built up a multi-state hospital, private for-profit hospital company.

38:04And while they were doing that, like many health systems, they also acquired the providers in those communities as part of their ownership. So they had both a hospital system, Florida, Arizona, Western PA, Massachusetts being the biggest, where they had hospitals and a network of providers. Over the course of the last several years, Cerberus sold the business through a leverage recap. And that leverage on the businesses with a lack of reimbursement ultimately led the business to file for bankruptcy. But in December of 23, Stuart, prior to bankruptcy, looked to sell their provider group. So they took all of their providers, put them under a basket of ownership called stewardship within Stewart and tried to sell it.

38:45We looked at that opportunity. We bid to acquire those assets. United Healthcare ultimately agreed to acquire those assets for$850 million. And in May, Stewart filed for bankruptcy. Everyone thought that United was going to proceed with the acquisition of the stewardship hospitals at this$850 million. And right around Memorial Day, it began to leak through the system that maybe United wasn't going to be there. We got called back in early June of 2024, if we were still interested in acquiring the provider group out of stewardship. We said, yes, we see it as a great opportunity. These are primary care doctors in low-income communities serving patients.

39:26And it's an opportunity where we can continue to do the things I said in terms of investing in technology, investing in mid-levels, helping these doctors extend their careers, bring them capital to recruit new providers into their practices. So a lot of opportunity to stabilize the system and grow it. Ultimately, we ended up being the only bidder. So much to our surprise, and I think we were the only bidder for one reason, there's a lot of negativity in the things associated with private equity owning healthcare right now. The centers from the state of Massachusetts have been vocal that private equity should not own healthcare.

40:00And I think a lot of people just shied away from the opportunity. We leaned in. We think that this is the right thing to do. This is the right set of doctors. We have the right leadership. So we signed a purchase agreement in August of 2024 to acquire the assets of stewardship, publicly announced$245 million. So a much reduced price from what, at least at one point, United seemed interested in paying and will have a great group of people and providers that are going to serve the communities that they're in. It's been announced that Massachusetts on August 31st, they closed two hospitals. Those communities are going to have less access to healthcare.

40:36Maintaining their providers in those communities can be very important and having a network of providers that continues to exist there. So that's what we're excited about. We were surprised to be the only bidder. There's been noise recently since we bought it that maybe private equity is not the best buyer or Kinnerick's not the best buyer. I think that's unfortunate. It lacks substance in fact, but it is something that we believe will overcome. And we're very confident that our management team and the providers that we've met with and spent a lot of time are highly supportive of us coming in and helping them.

41:09We've had near universal support from the over 300 employed providers in the state of Massachusetts that they want rural health groups slash kinderhook to be the acquirer of these assets. So we feel very good about where we are. How do you think about underwriting the risk that you have all of this noise, particularly in say Massachusetts' core market, that someone along the way changes regulations to make the business much less attractive than you think it would otherwise be? That's a great question, Ted. And government programs, healthcare, stroke of Penn risk, as it's called, is something that people are very concerned about and have been concerned about.

41:44We've had success building companies in hospice, in home health, in government Medicaid and Medicare HMOs. We've been in the clinical research space. Clinical research, as you might imagine, if you think about it, most new drug development is paid for, obviously, by drug companies, but those drug companies are supported by the high demand for new pharmacies that are paid for by government programs. So our whole ecosystem in healthcare is really driven by government demand and government intervention. If you're going to be a participant in healthcare services, I would say you have to be comfortable with that risk.

42:17And it comes back to delivering high-quality care, the stroke of pen risk or the noise. I think it's interesting. Gavin Newsom recently vetoed legislation in the state of California to put further oversight in the acquisition of healthcare investments in the state of California. So the pendulum swings. It swings back and forth, but ultimately patient satisfaction, success by delivering high quality businesses, I think is what will stem this pendulum, which I think is swung in a very negative direction right now to come back to a center where you see people confident in the ability to grow value, deliver service to members in the support of these government programs.

42:58At the end of the day, it may sound cynical, but politicians are there to serve their voters and voters aren't going to be happy when they don't have access to healthcare. What's your game plan with the business and taking it where you've bought it and seeing how you can improve it from here? This has been a very under-invested in group of providers. So these providers, because of the financial constraints that Stuart had, did not hire new staff. They haven't done anything to improve the environments that their physicians are working in. So the first thing we're going to do is invest into the business, infrastructure, signage, reception rooms, medical product.

43:34So we'll restash the closets for Band-Aids, so to speak, because in the primary care, it's shocking where these businesses have come to. We will be bringing in new technologies to help electronic medical records, share records amongst the providers and amongst the health systems that service the patients and the specialists that service the patients to create efficiency. We'll invest in mid-levels, capital to bring in people and staff and look to open new clinics. Ultimately, growing populations, you want to have new clinic growth and expand service. We will do it in the markets that we currently serve.

44:05We have enough footprint in Massachusetts is the biggest, South Texas, Arizona, and Florida, the four largest markets that Stewart had. We'll stay in those markets and grow density in those markets. And ultimately, look, we are private equity, part of what private equity does. We buy businesses, we build, improve, and grow those businesses, and we sell them. We're passing the baton to the next buyer. We believe when we invest in and grow this asset, there'll be many interested buyers, including hospital systems, HMOs, maybe this company's of scale. It could have public market access at some point, but our job is to buy, improve, grow, and sell.

44:43And that's what we'll be looking to do with the asset. How do you think about the return on investment in those investments you'll be making in the business when it's already a low margin business? That's a great question. Where the leverage in the business comes from is from scale. So where the incremental margin is what's known as full risk contracts, this value-based care, people have heard this term floated around. The reason that value-based care works, it's because it provides alignment between the patient and the provider. So that's the purpose of value-based care. It's something that the government has talked about, accountable care organizations, that's a government incentive program to create patient-provider alignment.

45:25MIPS was another one. DCE was another one. There's multiple programs over the last 15 years that the federal government CMS has implemented to create patient-provider alignment. Very few of them have succeeded. Value-based care is the effort really of the market to do exactly that. And the reason it makes sense is because ultimately as a provider, by taking risk, you put yourself in the position and think about primary care where you're trying to make sure that the patient is taking care of themselves before there's a billable event. So sharing in the savings of that cost is what value-based care is.

46:00It creates an economic alignment between the patient's health and cost containment that allows providers, doctors to make more money. And those shared savings go across the network that allow us to invest in the growth of the networks. And the more those networks grow, the more power they have in negotiating provider rates with the payers. How do you think about what success looks like in this investment? Well, success here will be one, improves quality scores. So we will drive up the HEDIS scores, STAR scores across our network, that will be tangible and it'll be seen. It's one of the metrics.

46:35These are the state, local, federal government standards where they measure quality. And our goal is always starts with quality. Two will be patient population growth. So census growth for our providers. If we can get their census from taking care of, I'm just making up numbers, 100 patients to 150 patients on their patient panel, that means we have broader reach and broader access to the community. And then growing those providers because ultimately, again, it's a free market. Providers choose. Providers that are with us, they can quit. They can go across the street and if you're in Massachusetts and go work for Beth Israel or Mass General.

47:08They don't have to work for stewardship. They choose to work with stewardship because of being good partners. So that network in the last 18 months has shrunk. People have left and chose to leave stewardship because of the leadership, bankruptcy, whatever. our success will be growing that network and having people be choosing our business going forward. So those will be the metrics of success and it'll be tangible in patient experience, provider satisfaction, and ultimately the financial success of the business. I want to ask you guys a couple of closing questions before I dive into that. I'm really curious what you think are the most important lessons you've learned from either coaches in your football days or mentors along the way?

47:51In retrospect, as a parent and as a coach, what I learned is that parents who care, coaches who care, get better outcomes from their players, from their children. So being private equity investors who care, being a manager of a firm who cares about its employees, we ultimately get better outcomes from our team, from our executives. It's almost human nature. I never thought about it when I was a child. I never thought about it when I was a player. But I sit here today, the fact that my coaches cared about me made me feel compelled to want to do better for them. The fact that my mom and dad cared about me made me want to do better by them and make them proud.

48:34So that, like I said, I believe it's human nature, but I think it gets lost. I would say the beauty of team sports is that you have to play your responsibility. and you're accountable for your individual contribution to the team. And if you carry your water and trust the other people, getting that word trust, then you're going to have success. And it gets back to you can't blame. So when you're an offensive lineman, you go to the line, you got to make your block. If you don't make your block, you have the lookout block. Somebody gets hurt behind you. But it requires everyone to be coordinated and move as a unit.

49:07And there's going to be weaknesses and failures. And if you go back to the huddle and you start fighting, you're not going to succeed. And if you go back to the huddle and say, we got this, and we work together, you're a servant to your teammates, that's what leads to success. And I think that's what I learned being a player, and in particular, a football player, is that you are there for the team. And when you're there for the team, the team succeeds. As you guys look at your business and all the changing dynamics in the private equity industry, curious how you look out over the next couple of years and what you want to do, both strategically and to continue the success of Kinderhook?

49:43If you're not growing, you're dying. So we need to continue to grow our firm. We need to continue to grow our fund size. We need to continue to invest in our people, our infrastructure. We continue to develop our young talent. So create an opportunity for the team. When people don't feel like they have opportunity, they go elsewhere. And there's been a lot of investment into this team and organization. So that's probably the most important thing. Because of the talent that we've been able to foster within our firm the last several years, I think we have the opportunity to continue to spread our wings.

50:14We did a lot of environmental services. We now do industrial services, and that's become very powerful, additional within that vertical, but it could be a vertical in and of itself. And our industrial services business has been very successful. We continue to develop our organization in these areas of expertise, and it helps us leverage our operating partners. I think the other thing is, quote, old guys, look for all of our operating partners that have been with us for 20 years, just like building our own team, we need to bring in new, young, talented operating partners. We're doing that, but it's very important.

50:45If you want to continue to deliver value, you have to have CEOs and waiting, so to speak, people that you trust to step in and lead the businesses you buy. All right, guys, I want to make sure I get a chance to ask you a couple of closing questions so we can go with both of you. Hopefully, it won't be the exact same answer. We'll see. What is your favorite hobby or activity outside of work and family? Chris, why don't you go ahead? I love to fish. And fishing is fun. It takes talent. It's a little bit mysterious. You don't really know what you're going to pull up. You don't know if you're going to be successful.

51:13You don't know what factors affect your success. Is it weather? Is it me? Is it the bait? So do a fair amount of fishing, both fly fishing, saltwater and freshwater, and offshore fishing as well. But really enjoy the fly fishing and casting for fish. Trolling for fish can be fun, but it's really more fun to actually fish and be out there and it gives you time away. You're on a river, you're out on a boat, you're away from your phone, you're away from a big group of people. So it's a real change from what we're doing or I'm doing every day. Same answer. All right, Rob, let's try this one. What's one fact that most people don't know about you?

51:47That my exciting accent is actually a speech impediment. There's no such thing as a Detroit accent. That's called being born second. I kicked him on the way out. All right. Chris, what's your biggest pet peeve? Probably when my brother tells me I'm wrong. Rob? Same answer. What I actually had in mind is laziness. The least you can do is make an effort. All right. Rob, which two people have had the biggest impact on your professional life? I have a feeling I might know who one of them is. I could say a lot of people, but obviously it's my brother and then it's my wife. because my wife let me work with my brother.

52:25So Chris, that's a good answer. Thinking about people outside of the family, a gentleman named Jeffrey Keenan has been a mentor to Rob and I. Rob worked for him back at UBS 30 years ago. And Jeffrey's been a consistent voice of reason and someone that has clarity of thought and has been willing to do things for us professionally, step into operating roles, step into all kinds of situations to be helpful. So Jeffrey's truly been a great business mentor. And the other person, our partner, Tom, it's a unique person to say they want to be partners with identical twins. And we all have strengths and weaknesses, but Tom had the vision, the courage.

53:10Tom said, hey, I want to be partners with these two guys. And that's led to our collective success amongst the three of us. So Tom's been a great partner and someone who has a lot of foresight and character to be able to manage what, as you can see, is a pretty complicated situation. What's the best advice you've ever received? We went to Catholic high school and it always set up on the side of the gym, God's gift to you is who you are. Your gift to God is what you make of yourself. And it's somewhat cliched, but ultimately you're responsible for yourself. We all face adversity. We don't achieve the things we want.

53:44But ultimately, if you have a positive attitude and you continue to think, what am I trying to achieve? You can be successful and persevere. And so I think that just having that in the back of your mind and say, hey, what can I do to be more successful? I think it's just there that you have to think about that all the time. Rob? Our high school football coach was a great communicator and he would come up with expressions and themes. And one of the themes I always remember is there's magic in believing. And it's one of those, you got to believe in yourself. You got to believe in the people around you.

54:18You got to have faith. And I think it's been a great lesson. All right, guys, last one. What life lesson have you learned that you wish you knew a lot earlier in life? We were very fortunate to start Kinderhook when we were relatively young. We're 33, 34 years old when we decided to try our hand to start our own firm. And I think in hindsight, fortunate because life moves fast. If you're going to bet on yourself, bet on yourself. And I think about young people today, and it seems like adolescence extends later and later and later in life, but you're not young forever. So I encourage young people to believe in themselves and bet on themselves.

55:00I think it's a great thing. All right, guys. Thanks so much for sharing this very connected experience you guys have had together. Thank you, Ted. Really appreciate it. Thanks, Ted. Thanks for listening to the show. To learn more, hop on our website at CapitalAllocators.com, where you can join our mailing list, access past shows, learn about our gatherings, and sign up for premium content, including podcast transcripts, my investment portfolio, and a lot more. Have a good one and see you next time.