Why All the Deals in the Work Comp Space?

Tuesday, January 11, 2011 | 0

By Joe Paduda
CompPharma and Health Strategy Associates

The investment community's fascination with the work comp services space resulted in a half-dozen deals over the last couple of months, on top of several more earlier in 2010.

Which has led some to ask? Why this industry and why now?

The "macro" answer to the "why now" question has to do with the tax treatment of investments, the expiration of the Bush tax cuts, and a desire on the part of many owners to cash out before those cuts expired. While they didn't, the work was still well under way by the time the final deal was cut so things just kept moving.

There's also a lot of money sloshing around in investors' bank accounts waiting to be used, and lots of pressure on private equity firms to put that money to use.

The "micro", or industry-specific answer, is a little more complex.

First, private equity loves immature, technology-starved, process-heavy, decentralized businesses. By rolling up similar companies, investing in technology, standardizing processes and hiring strong leaders, owners can reap outsize rewards through increased efficiency, the removal of competitors, and lower cost structures.

Second, the comp industry has been moribund of late, stuck in the mud due to declining frequency, low claims volume, excess capacity (in insurance, claims administration, and related services) and a horrendous employment picture. But that's about to turn. According to an analysis by JMP Securities, "For the 2010/2011 filing season, 13 states increased rates compared to eight in the prior period. Importantly, rates are rising in some of the largest states including California, Florida and Illinois (collectively 27% of nationwide workers' comp premiums)."

Now that hiring is improving and injuries are trending up, investors expect to see significant organic growth. This growth may be somewhat artificial as it's coming after several awful years, and will in all likelihood taper off a couple years out, but it's growth nonetheless.

Third, many of the companies that populate the comp trade show floors were founded a couple decades ago by entrepreneurs, some of whom are now looking to take a few chips off the table. For those that have worked smart and hard, those chips have lots of zeros attached.

Fourth, over the last decade, third-party administrators (well, many TPAs) have changed their business model from making money from claims handling fees to making more money from managed care and claim service fees. This pumps up the top line and profits. The more aggressive TPAs have pushed beyond collecting fees and commissions from vendors to acquiring them outright, further enhancing their financials. This isn't necessarily a bad thing, as long as their customers know where their dollars are going.

What does this mean for you?

Make sure your contracts have a survivability or change in control clause.

Joe Paduda is co-owner of CompPharma, a consortium of pharmacy benefit managers, and owner of Health Strategy Associates, a Connecticut employers consulting firm.