Mergers and Acquisition

The resurrection of the PEO industry is due to a number of factors, not the least of which is the decrease of affordable workers' compensation coverage. Since 2003, workers' compensation rates have fallen by a total of 40 percent and experts agree that another decrease is likely to come in 2008. Largely attributed to the 2003 workers' compensation reforms, the reduction in rates has resulted in a steady stream of new carriers entering the market or existing carriers adding workers' comp to their lines of business. At the same time, more employers have become attracted to leasing companies as an affordable option to outsource their human resources' needs.

This intersection of lower workers' comp rates and employers' desire to outsource many of their human resources needs have combined to salvage the PEOs reputation and increase the popularity among business owners. PEOs now offer employers a wide variety of services that include managing payrolls, institute safety programs, and ensure that all state and federal regulations are met. By providing these services, PEOs are allowing employers to focus on their primary goal of expanding their business and adding to their bottomline.

One measure of the health of today's PEO industry is a boom in the number of mergers and acquisitions. Wanda Silva, president of Kennesaw, Georgia-based Silva Capital Solutions, said the upswing in buying and selling of PEOs is being fueled by a number of variables, not the least of which is the popularity of outsourcing among employers. She said this has made PEOs attractive to firms that are searching for places to invest capital. Silva Capital has completed 29 PEO transactions and provided consultant services to more than 400 firms.

Silva divides buyers into two different categories: financial investors and strategic buyers. Financial investors typically consist of venture capital companies or private equity firms that invest in a PEO with the goal of increasing its value so that it can be eventually sold at a profit. As is the case with many such investing firms, the goals are short-term, and the fact they chose to invest in PEOs is concentrated in the investment potential and not necessarily because they are leasing companies. It is not unusual for such firms to acquire a number of PEOs and by consolidating them, significantly increase the leasing companies' overall value, which, in turn, earns the buyer a higher yield on its investment.

Strategic buyers generally are long-term players in the industry whose expertise is in owning and operating PEOs. As a result, the buyers have a different motivation that often centers on expanding their current position in the marketplace. For example, the buyer may be looking to expand into another geographic area, offer new services to employers, or enhance its current expertise in the areas of sales and technology. Since strategic buyers are entrenched in the industry, their focus is less on an immediate return and more on the long-term growth of its operations.

Silva said that the current economic conditions have helped push up the value of PEOs. From her perspective, she said that the industry is in the “middle state” of its growth trend as private equity firms and Wall Street have become more knowledgeable about the industry and the financial factors that influence the PEO market. “Our industry is not the new one on the block,” she said.

She also stressed that right now it is a “seller's market.” Given the rising number of active buyers; there are now more buyers than PEOs and the valuation of the leasing companies has grown exponentially. Buyers look at several key factors when determining the profitability of a PEO, although this list is by no means exhaustive. The list includes annual revenues, gross profit, and earnings before interest, taxes, depreciation, and amortization. That formula and the attractiveness of PEOs as an investment vehicle is seeing sellers financially benefiting from selling their business. “Typically, sellers are getting higher than what the PEO is valued,” Silva said. “They are getting four and six times what the PEO made in one year.”

Due Diligence Key

One thing is clear: Even though the PEO industry is attracting many investors, the investors are being much more cautious when evaluating a company. That is especially true with respect to a PEO's risk management program. Silva said that this was the number one lesson learned by buyers in the mid-1990s. During that round of mergers and acquisitions, many buyers proved to be unsophisticated and didn't perform the type of analysis needed to determine the leasing company's long-term financial prospects. “The due diligence on risk management and workers' compensation was very poor, and a lot of buyers didn't survive,” she said.

She said buyers now want to see the PEO's complete records, especially when it comes to workers' comp claims. Silva said that PEOs could increase their value showing if they have sound management teams and a proven track record of stringent underwriting criteria, along with a program to aggressively respond to workers' compensation claims. “Buyers want to see every document on a workers' comp claim from the beginning to the end,” she said. “If you handled it right in the beginning, then the buyer trusts what you're doing is right.”

Risk Transfer Senior Account Executive Jennifer Robinson agreed with Silva, saying that potential buyers are zeroing in on a PEO's risk management program and insurance contracts. Incorporating the lessons learned in the previous round of mergers and acquisitions, she said that prospective buyers are placing more emphasis on risk management services. “Buyers are much more loss sensitive and, in addition to looking at the balance sheet, they want to see the details of the policy and look at the safety programs.”