Why M&A makes sense for large HRO providers looking downstream. Just beware of the pitfalls involving employee morale, the customer base, and other issues around acquisitions.
!n the past year, the HR management sector has experienced a rush of merger and acquisition activity. Since January 1 of last year, more than 200 U.S. transactions have involved companies in this and the outsourcing sectors. Why has M&A activity ramped up, and what can we expect for 2007?
Answers to both questions lie in understanding the changing landscape of the mid-market. Witness the recent acquisitions of providers Employease and VirtualEdge by ADP and Accenture’s purchase of Savista. Clearly, these large providers understand that smaller providers bring value to their organizations.
But why?
Smaller providers bring client lists and new technology. In most cases, purchasing small to mid-sized companies that possess cutting-edge technology proves more cost effective than developing the technology. Larger providers are thus able to keep up with market momentum while increasing their client base.
Other cost savings are significant also. Smaller and mid-market companies are beginning to embrace the idea of outsourcing more HR functions, thus adding to the demand for services. Costs, once thought only affordable to large organizations, have become attractive to organizations of all sizes. The cost per employee to create an in-house HR management system averages $2,727 for a 500-person company.1
However, for the same 500-employee organization, an outsourced human resource information system costs between $500 and $1,000 per employee—nearly a third less than an in-house system.
Because small and mid-market organizations have not invested much financially in HR, providers serving this market are growing rapidly. HRO providers targeting these organizations are creating a standard service offering capable of addressing the needs of 500- to 2,500-employee companies with minimal customization because they do not need to work with legacy systems. Often, mid-market HRO providers are in a position to provide flexible solutions based on the technology and systems they already possess.
Larger HRO providers, however, are not always well positioned to capitalize on the growth of the middle-market segment, nor do they always have the right product set. More and more, cutting-edge providers are using acquisitions as a strategy to enter into new markets and gain access to new products. For larger suppliers, the client-base, solutions, and add-on services that smaller entities provide make them very attractive acquisition targets.
And it’s not just a growth strategy; it is also a profitability play. In current market conditions, as the smaller market opens up to embrace outsourcing solutions, providers can expect and demand higher margins.
Given that M&A in the HRO space will speed up and not slow down, how can a company know which targets to go after? And what should the owners of target companies think about? The remainder of this article addresses what buyers and sellers should know as they approach a possible transaction.
THE ACQUIRER’S PERSPECTIVE
For large HRO providers, acquiring a company focused on the small or mid-market can make sound strategic and financial sense. But to be confident in selecting the right company, it is vital to understand the financial, operational, and technical objectives of an acquisition and to get a strong sense of the full range of acquisition targets that may be available at a given point in time. Once a “short list” of acquisition targets has been identified, the buyer should turn to the strategic advantages each can bring to the parent and weigh the cost/benefit as well as the “build or buy” equations.
Final selection often hinges on a combination of strategic fit and the projected financial value of what the target will bring to the buyer organization. Buyers should take care to uncover how the pricing, margins, and base costs compare with others in the market place to be certain you have chosen a quality target.
The buyer also needs to understand the components of the target’s valuation and whether a transaction is accretive to profits before both companies enter into negotiations. While valuing a company is a complex process, there are several ways to uncover its worth. Arriving at fair market value involves both hard figures such as assets, liabilities, earnings, and cash flow, as well as soft figures including projected earnings, future cash flow, and other intangibles.
Current market conditions, standard industry multiples, and the objectives of the seller and buyer also come into play.
In addition to understanding the financial value of a potential acquisition, take a hard look at the operational attributes the company brings to the table.
What are the other aspects that make the company a good target?
• Strategic Capabilities. Understand what it is that the company brings to your organization. For players in the HRO space, it is important to be sure that the target’s market, core services, and technology can eventually align with the acquirer’s strategy.
• Industry Specialization. When HRO providers look to increase market share, acquiring a smaller provider operating in a niche can boost business quickly and provide a platform for future growth.
• Technology Platforms. New technology is emerging constantly in the HRO world. Smaller players are often equipped with the technology to create a robust solution that can service clients of all sizes. Understand what technologies your organization can utilize and leverage once the deal has closed. In particular, an HRO provider should already address a move to .net architecture.
• Management. One of the biggest indicators of how a company will perform once it is acquired is its management team. How strong is it? Is the team willing to grow with the additional resources your organization will provide? If not, be sure to plan for management succession well in advance.
FROM THE SELLER’S PERSPECTIVE
While larger enterprises seek out smaller ones to acquire, smaller players may also be conducting their own searches for buyers or investors. Just as potential buyers must understand the key financial and managerial aspects of target companies, owners need to be prepared.
While being a desirable acquisition target is an enviable place to be, selling all or part of one’s ownership stake can be a long and emotional process. If you are not sure if you want—or need—to sell, here are some considerations:
• Growth Trajectory. Are you able to envision where your next million dollars in revenues is coming from? Are you uncertain that you can continue to grow over the next five years? Mapping out a clear strategy for growth and considering what the competition will look like in five to seven years can help answer those questions.
• Access to Capital. Do you have sufficient capital from your bank or private investors to reach your potential for growth? If needed, would you know where to turn for financing? If the answer to that question is “no,” it might be time to investigate options.
• Management. Is the management team energized by being an independent operation? Or are you and your senior management beginning to dream of retirement? Creating a succession plan for your business may help to uncover the future.
• Purchase Price Multiples. Current multiples for publicly traded HRO services and consulting companies are approximately two times revenues and 10 times earnings before interest, taxes, and depreciation. Are you willing to take a bet that multiples will be the same or better for your business in five years? Or has your business reached a point where in five years it may not be as valuable as it is today? Take a look at your competitors to see what direction they are headed in. It might provide additional insight into the industry.
• The Character of the Suitor. Is your suitor a strategic or financial investor? Is it a company you admire? Do you have a desire to be a part of the team and its culture? Think of this for not only your own personal future but also the future of your employees. Is there sufficient room for your top players to grow within a new organization?
• Client Base Value. How solid are your customer relationships? Would they defect if there were a change in control? It is important to understand that a change in management can be upsetting for some. If 25 percent of your revenues is to one client, be comfortable with the idea that it may leave.
If you are looking to sell to a financial investor, many private equity and venture-capital firms have time horizons associated with the liquidity of their investments. Typically, financial investors want to “turn” their investments within three to seven years, depending on the market conditions, portfolio company performance, or the life of the investment fund.
When debating whether to raise capital from an investment fund (a private equity firm or venture capital firm) or sell to a strategic buyer (an existing organization within the HRO space), sellers should consider their commitment to growing the company aggressively and/or relinquishing the reins.
Both sides reaching acquisition terms is only part of the work. Here are some pitfalls to avoid.
• Corporate Governance Issues. Navigating around compliance can be one of the most challenging parts of a deal. Tax and Employee Retirement Income Security Act (ERISA) regulations specific to the employer-employee relationship vary by locality and can change frequently. Sarbanes-Oxley compliance and the Privacy Act of 2005 add additional layers of complexity.
• Integration Challenges. Be sure the due-diligence process includes a review of not only the financial and managerial aspects of the business but also logistics. This process takes expert planning, skills, and experienced management. Technologies will need to be merged, and employees will need to integrate into a new culture. By designing a roadmap for the merger, senior executives on both sides will understand what needs to happen when.
• Loyalty of Employees. Keep in mind that owners of smaller companies may have strong emotional ties to the organization and its employees. When an owner sells, the company may face losses in morale and productivity, not to mention increased turnover among both employees and customers.
With M&A activity high in 2006, I am sure that 2007 will herald even more action. And as the HRO industry continues to change, strategic acquisitions will become a popular way for larger providers to retain a competitive edge. With the right due diligence on acquisition targets, and attention paid to potential pitfalls, HRO providers can put themselves in position to be on top of the food chain. Buyers and sellers both stand to profit when the process is conducted professionally.
1 Source: The Hunter Group
