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The burgeoning market for business-process outsourcing in human resources applications and functions holds ample opportunity for growth—but also some daunting challenges for vendors seeking to take part.

First the good news: A recent Yankee Group report predicted that the global HR BPO market will grow 27 percent in 2005 and continue to grow at a compound annual rate in excess of 30 percent through 2009.

More than ninety “high-end” HR BPO deals are in the works among Fortune 2000 firms, according to Phil Fersht, a Yankee Group research vice president who leads the company’s Multi-Discipline BPO practice. About 200 to 250 other companies are exploring HR deals that could lead to more BPO work.

Fersht said greater awareness of the practice among senior managers beyond the HR department has boosted HR BPO’s prospects. And test cases that demonstrate 20 to 30 percent cost savings and improved HR services certainly help.

Industries where the outsourcing of HR is common include telecommunications, pharmaceuticals, manufacturing and retail, Fersht said. Health care and government are also likely candidates, he added.

But HR BPO opportunities come with some sobering realities. HR BPO is a demanding market. Vendors need a mix of HR consulting and IT expertise. Fersht pointed out that they must also operate multinational contact centers and possess the ability to monitor and adhere to service-level agreements.

Doing all of the above while making a profit stands as perhaps the most difficult challenge, particularly amid fierce price competition. Fersht said vendors routinely drop prices to seal HR BPO deals. “This is a tough business, in which vendors need scale to survive,” he observed.

Fersht points to Exult Inc., a pure-play HR BPO vendor that he credits with kick-starting the industry. Exult grew rapidly, but ultimately lacked the scale to continue to grow at its accustomed pace, Fersht said. Hewitt Associates acquired Exult last year and is now the market-share leader in HR BPO.

For more on how and where the HR BPO market is growing, click here.

Hewitt Associates faces competition from top-tier global BPO providers such as Accenture, Affiliated Computer Services, Convergys, Electronic Data Systems, Fidelity and IBM, Fersht said.

Like Hewitt Associates, some of the challengers have gone the acquisition route to bolster their market position. ACS earlier this year agreed to acquire Mellon Financial Corp.’s HR-outsourcing business. That deal is expected to close by the end of June. EDS’ HR-outsourcing joint venture with Towers Perrin provides a variation on the theme.

Fersht suggested that IBM may also opt to acquire HR expertise. He said IBM has done reasonably well in the market, but needs to acquire consulting capability and HR transformation skills, he said.

But as some vendors bulk up, others will look to sell or simply leave the market, Fersht said. The requirement for extensive scale may prove too much for some providers. The high-impact nature of the work may give some vendors pause as well. Business processes such as payroll and benefits administration directly affect the health and happiness of an organization’s employees, Fersht said.

Watch for the market shakeout to continue this year.