Human resources management is one of the most substantial and promising areas in outsourcing today. One of our favorite models is the professional employer organization, or PEO. The value proposition PEOs provide enables clients to cost-effectively outsource the management of human resources, employee benefits, payroll, and workers’ compensation, allowing them to focus on core business functions. PEOs deliver these services by establishing and maintaining an employer relationship with the client employees and by contractually assuming certain employer rights, responsibilities, and risk. We believe that significant investment opportunities exist in this consolidating market given the fast growth and low overall market penetration.

The PEO industry was recognized by The Harvard Business Review as the fastest growing business service in the United States in the 1990s. Annual industry revenues today are approximately $50 billion and growing 20% year-over-year. Furthermore, the estimated addressable market penetration is only between 3% and 20%, translating to a market opportunity of $250 billion to $1.7 trillion. Better still, the PEO market remains fragmented, with some 700 PEOs in business today. With a strong platform company, seasoned management and the right financial backing, there is a great deal of potential to grow a company both organically and through acquisitions.

In addition to pursuing growth initiatives, we feel that there is a significant opportunity to use technology to scale a PEO business. Scott Klososky, a leading consultant to the industry and former keynote speaker at the National Association of Professional Employer Organizations (NAPEO), notes that “the PEO industry is poised to take advantage of the technology trend of Service Oriented Architecture which would allow PEOs to easily connect to existing job costing software, time and attendance systems, and accounting systems in order to both receive payroll data and export completed information back to clients. This further lowers the barrier of entry as an outsourcing provider. This level of automation both increases the attractiveness of a PEO to a client, and lowers the internal operating costs.” This point fits well with Virgo’s belief that adding value to an investment consists of growing top line revenue as well as reducing costs by working with our strategic partners to leverage scalable technology-enabled solutions.

Looking deeper into the PEO space, we see two distinct business models, one where the PEO serves blue-collar workers and another with a focus on white-collar workers. The former is largely an insurance and workers compensation play where companies benefit from reduced premiums through employee pooling and risk sharing, and the latter is grounded more in the traditional outsourcing value proposition. Both models can be lucrative, but each one has distinct risks and rewards. As an example, blue-collar PEOs require an in-depth understanding of risk management, while white-collar PEOs are much more focused on technology capabilities. A recent trend in the PEO industry is to provide the same HR services in an a la carte manner and to not contractually assume full employment obligations. This model, known as the administrative services organization, or ASO, model, has its advantages for a category of clients that want to outsource certain modules of human resources efforts.

Finally, the PEO market is consolidating one, and we believe a few strong leading players will emerge in the coming years. As that consolidation takes place, there will be good liquidity opportunities for scaled, differentiated PEOs. Private equity firms have been quite active in the space of late. Recent investments include Strategic Outsourcing, Inc., with 32,000 work site employees (WSEs), which was purchased in 2005 for $80 million, and Oasis Outsourcing, with 55,000 WSEs, which was acquired in 2006 for $130 million. Given the growth of the market, many investors will do well by simply adding bulk. However, the investors that will truly differentiate themselves are those who partner with the right team and company and help drive a focused strategy, which includes disciplined growth, both organic and through acquisition, and exceptional client service.