For Private Equity Firms Interested In The PEO Industry

Introduction

The PEO model is a hybrid of an outsourcing and consulting model for small and medium sized businesses (SMBs).  Typically, a PEO offering consists of:

• Human Resource Outsourcing and Consulting
• Risk Management and Safety Consulting
• Payroll Processing & payroll tax filing
• Human Capital Technology (payroll, HRIS, CRM, etc.)
• Workers’ Compensation Insurance
• Health Insurance
• Employment Practice & Liability Insurance (EPLI)
• Regulatory Compliance Assistance
• Retirement plans
• Potentially Recruitment & Staffing Services
• Additional niche or ancillary services

A well run model generates positive cash flow and a certain level of predictability on earnings.  The PEO has two main profit pools.  Administrative fees which it charges for its services and premiums collected if the PEO utilizes an internal high deductible for insurances.  While there are ancillary profit pools within the model, the two aforementioned pools generally represent the majority of earnings. There are two primary potential detractors from earnings.  The first is greater than expected insurance claims.  Claims may affect earnings from recent activity, a maturation of older claims (claims tail) or both. The second is client attrition.  On average, the industry hovers between 87% and 92% for client retention.  Numbers below this range should be investigated.

Industry Overview

The PEO industry is in a growth stage.  While the competition level is high, the market penetration is low. Current market penetration is at an estimated five to seven percent. The PEO Industry gross revenues were estimated to be $168.3bn for 2016.  Gross revenues are inclusive of worksite employee (WSE) payrolls.  Net revenues were estimated to be $22.9bn in 2016. This represents an average client markup of 15.75%.  There is estimated to be between eight and nine hundred PEOs in existence today.  However, the industry is top heavy.  The top three players represent half the industry’s gross revenues.  The top ten players likely control three quarters of the industry gross revenue.  For further industry statistics and commentary, click here.

Investment Considerations

While this article won’t cover all of the items a PE firm should consider when reviewing the possible purchase of a PEO, we will cover the highlights.

Leadership

It likely goes without saying, leadership makes a difference.  Leadership could propel the PEO forward or cause it to stagnate post acquisition.  When considering the acquisition of a PEO, ensure leadership has the capabilities to drive the organization forward within the time-frame of the exit strategy.  If leadership is not appropriate for the PE strategy, source external or internal leadership to fill the gap.

Sales

While the angle of the hockey stick will likely be corrected during the formal due diligence process, a propensity for growth with historic indicators should be present unless the PE is buying a distressed asset.  A PEO with flat sales may have a go-to-market strategy issue, a poor value proposition, under-performing sales talent or the inability to price appropriately.

Technology

Technology matters on two primary fronts.  Externally, the features and ease of use help PEOs gain and retain clients.  Internally, a superior tech platform allows a PEO to scale more quickly and will improve the WSE to internal employee ratios.  The byproduct of internal tech efficiency is lower overhead which should equate to increased EBITDA.

Consulting

Human resource and safety consulting are two main offerings of the PEO model.  Review how the value proposition is delivered to the PEO’s clientele.  If face to face consulting is the primary delivery model, attracting and retaining the right internal talent is key.  If virtual consulting is the approach, systems, online libraries and capable talent are requisites.  Client retention is generally an indicator of how well the value proposition is received by the market.  High client retention is indicative of a superior value prop.  Low client retention generally means there is an issue within the service model that needs to be explored prior to purchase.

Insurance

Workers’ compensation, health benefits and EPLI are the primary insurances offered through a PEO.  Ancillary services such as dental, vision, etc. may also be present.  If the PEO is on a first dollar program (guaranteed cost), loss runs should be scrutinized to identify trends and the PEOs ability to select appropriate clientele and mitigate risk.  If the PEO is operating on a risk baring platform (internal high deductible), profitability, claims analysis, reserves and collateral requirements must be an area of focus. Actuarial consultants should be hired to review the insurance and claims aspect of the target.

Legal

Legal diligence should review contracts, liabilities, ERISA and other facets that have, are or may affect the PEO.  Legal teams familiar with the PEO industry are advised to ensure all rocks are overturned to understand any potential legal liability or holes.

Financial

Financial review is a main aspect of the due diligence process.   EBITDA add backs should of course be scrutinized to determine the validity and timing of proposed add backs.  Financials should be viewed in light of the design and execution of the business model.  Financials are a historic report card.  Will the financials be indicative of future performance?  If the pro forma shows a jump in projected EBITDA, there must be convincing business rationale as to why.  Financial review is essential but viewing the PEO as a whole is recommended to determine the true value of the asset post acquisition.

Tax

PEOs handle internal taxes and external payroll taxes for its clientele.  Multi-state PEOs have increased tax responsibilities.  Review of internal and external tax processes and liabilities is essential during the review process.

Regulatory

A PEO has regulatory compliance requirements from both a State and Federal level.  The PEO should be thoroughly reviewed to ensure the appropriate compliance framework and checks are in place.  This is recommended on the internal operations and client facing material.  A PEO has the ability to be part of the Employer Services Assurance Corporation (ESAC) or become a Certified Professional Employer Organization (CPEO).  Regulatory/auditing bodies provide a layer of confidence in the PEO and their financials.

Retirement Plans

Retirement plans should be reviewed to ensure ERISA compliance and that appropriate controls are in place to mitigate risk and liability.  Legal review of the retirement plans and internal structure are appropriate.

Private Equity Strategy

A well-defined PE strategy within the PEO space will help the investor achieve the desired results and provide the framework to entice new PEOs to join the PE.  While buy and build is the most common strategy seen in this space, do not neglect organic growth.  Also, synergies should not be limited to operational efficiency, redundancy elimination and economies of scale.  The strategy should dive deeper to ensure the ROI at the time of exit is exponential. The strategy should be determined prior to purchasing an asset if the PE is new to the space.

Consolidation

Once an asset is owned and a second is purchased, the real fun begins.  Synergies and the future prosperity of the new macro organization are a byproduct of the selection of the new asset and the ability of the private equity to combine the entities.  Some areas to consider when viewing alignment for consolidation are:

• Technology
• Value proposition
• Leadership
• Go-to-market strategy
• Value prop delivery method
• Organizational culture
• Geography
• Organizational redundancies
• Market segment focus
• Insurance platforms
• Internal controls
• Legal and tax
• Decision & Control levels

Final Thoughts

Investments in the PEO space can prove very lucrative to an appropriate private equity with a successful strategy.  The industry has a lot of white space and will be in the growth cycle for the foreseeable future.  A PEO can grow new business successfully in a robust or down economy if positioned appropriately.  If a strategy is executed appropriately and the right assets are purchased, a private equity can generate a positive return within the industry in a reasonable time-frame.  A private equity firm that is new to the space should align with industry experts to ensure the right approach is being deployed.

Author: Rob Comeau is the CEO of Business Resource Center, Inc., a management consulting and M&A advisory firm to the PEO industry. You may reach Business Resource Center, Inc. via www.biz-rc.com or (949) 510-1126.