Private Equity Interest in the PEO Space

Investment interest into the Professional Employer Organization (PEO) space has increased from Private Equity firms in the last 10 years.  PEOs generate positive cash flow from operations and the ongoing residual nature of revenue coupled with the high customer retention rate (90% on average) can provide a lower risk investment option to private equity investors.

Multiple PEO Acquisitions

In addition to positive operating cash flow and high client retention, when a private equity makes additional acquisitions to integrate with the existing PEO in their portfolio they receive two major benefits.

1. The private equity is able to realize cost synergies post acquisition between the two PEOs.
2. The larger the PEO, the higher the multiple on EBITDA received based on historic information.

3 Ways to Maximize the ROI at Exit

Let’s explore some of the variables that impact profit and future performance.  The seller of a PEO is looking to maximize their profit at the time of sale.  The private equity is looking to maximize their ROI post acquisition. It makes logical sense that the only way for a PE to garner a positive return is one of three ways.

1. Negotiate a lower than market price for the PEO in order to capitalize on the resale.
2. Purchase multiple PEOs so that the exit multiples are higher based on the accumulated size of the assimilated PEO.
3. Find a PEO with a propensity for organic growth so that it is larger when you sell it than when you bought it.

So which of the three should a private equity aim to achieve?  If available, all three.  A PEO that you purchase at a reduced price and combine with future acquisitions (acquired growth, synergies, economy of scale) with a historic track record of growth (organic growth) will yield the highest ROI upon exit.

The Often Overlooked Impact of Culture

Another variable to consider is organizational culture.  If you are planning on purchasing multiple PEOs prior to exit, cultural alignment is essential yet can be overlooked during the due diligence process. Culture can help expedite the assimilation and synergy process or wreak havoc during this transitional phase.  There are proven ways to analyze culture and provide valuable insight that will determine if an acquisition is right for your portfolio.

The Bleed Factor

Profit in PEOs often hinges on mitigating the bleed factor.  What are the variables that can be detrimental to a PEO’s profitability?

1. Insurance: workers’ compensation or health insurance can have a positive and/or negative impact on a PEO.  When a PEO has a risk bearing program (internal deductible) they are often able to provide more aggressive pricing to the marketplace.  When these programs are not appropriately managed, the tail from workers’ compensation claims or the impact in health care severity claims can punish a PEO’s profitability.
2. Client retention is important to profitability.  Retaining a PEO’s clientele allows for predictability with revenue.  A poor client retention percentage works as an erosion of organic growth.  For example, if a PEO brings on 100 new clients a year and has a 20% attrition factor, they are losing 20 out of 100 clients annually.  When the PEO is only 100 accounts in total size, they still retain 80 accounts.  However, as the PEO client base grows, that 20% equates to a greater number annually.  Let’s assume that the PEO has a client base of 1,000 and still grows by 100 new accounts per year.  With a 20% attrition rate, they are losing 200 accounts annually (1,000 X 20%).  If they are only growing by 100 accounts annually, they are netting -100 accounts.  A higher client attrition rate forces higher organic production requirements in order to offset the loss of existing clientele.
3. A poor service model can act as an indirect bleed factor because it impacts both the pricing advantages and attrition rate of a PEO.  If a PEO has a less than average service platform, they are more likely to sell on price.  This makes them live and die by the pricing sword.  Additionally, if a PEO has a poor service platform, their client retention rate will most certainly suffer.

Look for a PEO with a solid service platform, risk bearing insurance programs with a well-executed risk mitigation strategy and a history of high client retention.

Target Market

A service model is generally tied to the type of business the PEO services.  In other words, if a PEO has a white collar focus, the following is generally most important:

• Good health benefits options/pricing
• ACA compliance and reporting
• Superior tech platform with online access
• High level HR support

If a PEO has more of a blue collar focus, these areas for a service model are often most important:

• Good workers’ compensation options/pricing
• Successful risk mitigation strategy/underwriting
• Risk management consultative service and training
• HR consulting and solid claims management

While either PEO would likely have overlap on what they offer, the emphasis to safeguard internal profitability should be on protecting the areas of exposure for the PEO and their chosen clientele.

Scaling a PEO

The ease to organically scale a PEO geographically often depends on the type of service model employed.

For instance, if a white collar PEO handles their HR consulting in person, telephonically or via the web, they can generally scale quickly.  The rationale behind this is that a physical presence in close proximity to their client base isn’t necessary.  A web based platform can cover all 50 states immediately and if they are licensed for health insurance in all 50, they can provide coverage without a physical presence.  HR consulting can be handled via the phone and web and therefore a PEO with locations in only a few States can service a national footprint of clientele.

If a PEO is geared more towards a blue collar focus, it becomes more important to have a physical presence close to its clientele unless they have a phenomenal underwriting matrix.  The reason is that safety training is generally most effective for a PEO and its clientele when safety consultants are able to visit client locations and job sites.  The rest of the offering may be handled remotely.  To scale a blue collar centric PEO quickly, without acquisitions, a combination of a proven underwriting matrix coupled with local experienced risk management consultants is advised.

Which Risk is Better?

From my experience, PE’s often view a white collar centric PEO as a safer bet due to the lack of workers’ compensation tail exposure.  It is understandable that this assumption is made and it can prove to be true.  However, with a PEO has a risk bearing platform for health insurance and/or workers’ compensation insurance, historic results are more important assumptions.

Health insurance plans can blow up and cost the PEO much of its quarterly profit.  It can be argued that it is easier to change the safety behavior in a workplace to protect against the workers’ comp tail than it is to change how your workforce lives their lives in order to protect the health insurance exposure.

Whether your private equity is looking to acquire a blue collar, grey collar or white collar PEO, it is recommended to focus on the level of exposure with the risk bearing platforms vs. how well the PEO has historically mitigated its risk.   Look at the type of business that has been brought on in the last 2 to 3 years and contrast that with the preexisting book prior to 2 to 3 years ago.  Are they cleaning up their book or increasing their risk?  This will always be a moving target due to claims maturation but this may serve as a good indicator to gauge their success of protecting cash flow generated from operations.

Organic Growth

It is our belief that organic growth must be evident to warrant a competitive purchase price.  Acquisition growth is great and can expedite plans for expansion but should not be the only means for gaining market share.  If organic growth is reducing, stagnant or slow, the company is at the mercy of their next acquisition for growth. Organic growth provides confidence that the PEO can continue to generate cash flow from operations and provides a shield against client attrition.

If organic growth is absent, it would warrant due diligence in a few areas.

1. Is the go-to-market strategy effective?
2. Is the value proposition appropriate for the targeted industries serviced?
3. Is pricing competitive and in line with the value proposition?

Final Thoughts

Due diligence is the time to identify if a target fits within your strategy.  Whether you currently own a PEO or are looking to get into the space, it is advisable that a pre-acquisition strategy is formulated prior to bidding.  What is your timeline to exit and what is it that your investment committee is trying to achieve in the short and long term?  Once this is clear, identifying the appropriate PEOs for acquisition becomes an easier process.

Author: Rob Comeau is the CEO of Business Resource Center, Inc., a management consulting company that works with PEOs and Private Equity during the M&A process.  To contact us, please visit us on the web at www.biz-rc.com or via email at rob.comeau@biz-rc.com.