Annual Privatization Report 2013

Privatization of State Lottery Management

Subsection of Annual Privatization Report 2013: State Government Privatization

» Return to Annual Privatization Report 2013: State Government Privatization
» Return to Annual Privatization Report 2013 homepage

Federal law prohibits states from fully privatizing their lotteries through outright sales or long-term commercial leases, though many states currently outsource certain sub-functions within their internal lottery operations, such as lottery terminals, ticket systems, central data systems and the like.

In recent years, several states have taken privatization further, tapping private sector management to increase net lottery revenues in an effort to help supplement traditional tax revenues, which have been hard hit in the post-recession economy. Illinois became the first state to privatize the management of its lottery in 2011. It did so in return for a commitment from the private manager to increase net lottery revenues to the state. This pioneering contract prompted officials in other states to pursue similar initiatives in 2012. Indiana approved a private management agreement (PMA) for its lottery in the fall of 2012, and Pennsylvania and New Jersey launched lottery PMA procurements in 2012 as well.

Illinois turned over the management of its lottery operations to Northstar Lottery Group, a partnership between GTECH, Scientific Games and Energy BBDO, under a 10-year private management agreement (PMA) designed to generate hundreds of millions in additional revenue to the state over the life of the contract.

The PMA gives Northstar responsibility for lottery operations, management and marketing functions in exchange for a portion of revenues, though the state continues to exercise control and oversight over all significant business decisions. The deal requires state approval of Northstar’s annual business plans and gives the state the ability to access all information regarding lottery operations. Northstar retained all of the in-house lottery employees and even hired additional private sector employees.

Illinois’ PMA ties Northstar's compensation to its performance at enhancing lottery revenues, subject to a cap. Northstar receives an annual $15 million management fee with performance incentives for extra profits, but the contract includes a 5 percent total net income cap on the potential profits for the contractor, as well as penalties if the company fails to hit pre-determined revenue targets.

In announcing the contract, Illinois officials noted that the deal is expected to generate $4.8 billion for the state through 2016, a $1.1 billion increase over the revenues projected under state management. The results after the first year in operation were more mixed, as Northstar fell short of its $822.8 million first-year revenue target (something Northstar attributes to certain state actions that limited its ability to execute parts of its business plan). According to preliminary findings by lottery officials in March 2013, Northstar returned $757 million to the state in the first year—a record high, and a significant increase over the $690 million in net revenue in the last year of state operation—and lottery officials announced they would fine Northstar $20 million for failing to meet its targets.1 However, Northstar officials challenged the findings, estimating that revenues were closer to $781 million.2 At press time, a state audit was underway to validate the actual lottery profits in the first year.

The PMA model is designed to deliver better returns to the state, not only because the private operator is in a better position to run the business more cost-effectively than a state bureaucracy, but also because a private operator is given an incentive (subject to state oversight) to grow the business to increase net revenues. This growth is expected to come via expanded product lines, improved marketing to attract new types of players, and new outlets for lottery ticket purchases, all of which boost the lottery’s bottom line.

While Illinois may have been the first state to pursue a PMA for lottery operations, its success in using private management to boost lottery revenues has prompted other states to follow in its footsteps in 2012:

Indiana: In October 2012, the State Lottery Commission of Indiana selected GTECH Corporation in a procurement for expanded lottery marketing, sales, customer service and distribution services. The state has signed a 15-year agreement projected to generate an additional $2.1 billion for the state over the life of the contract (relative to in-house operation), increasing the Hoosier Lottery’s use of contracted services from 88 percent to 95 percent of total operations. The initiative is expected to generate approximately $500 million of additional net income for the state over the first five years of the agreement.

Like Illinois’s PMA, the state lottery commission in Indiana is required to review and approve the private manager’s annual business plans before they can be implemented. The transition to private management began in January 2013 and is expected to be completed by July 2013.3 According to former Governor Mitch Daniels, “In eight years, this may be the easiest and most obvious decision the state has had to make. Our lottery revenues lag far behind most states. With this contract, the only question is how much more money Indiana will receive than under the current system.”4

Pennsylvania: The administration of Pennsylvania Governor Tom Corbett launched a procurement in 2012 for a potential lottery PMA designed to maximize lottery revenue to the state, which is used to fund programs that benefit the Commonwealth’s senior population. In November 2012, the Corbett administration announced that it had received a bid that includes 20 years’ worth of annual profit commitments from Camelot Global Services PA LLC, an international lottery operator that currently operates the UK National Lottery and provides consulting services for state lotteries in California and Massachusetts. In return for a 20-year contract to manage day-to-day lottery operations, Camelot would commit to increasing net lottery revenue to the state, with a minimum guaranteed amount of $34.6 billion over the full contract term, an amount reflecting a significantly higher growth rate than the state has delivered over the last 20 years under in-house operation.5

Pennsylvania’s Executive Deputy Secretary of the Budget Pete Tartline—the Commonwealth's chief financial officer—discussed the benefits of the deal in a 2012 Reason Foundation interview:

[O]ver the last five years the (Lottery's) compound annual growth rate has been 2.3 percent on an accrual basis, and over the last 20 years it's been about the same on a modified cash basis. And we've never had more than five consecutive years of positive profit growth in a row. By contrast, the $34 billion bid we received from the bidder, Camelot, would provide assured, funded profit growth for 20 years. The lottery has never seen this level of annual year-over-year growth. […] We would have 10 years at a 5.8 percent profit growth rate under the most constrained of circumstances under a PMA—which we haven't seen in terms of performance of our own lottery operation—and 20 years of total guaranteed growth, which again, we haven't seen.6

If the private manager were to miss its annual target in any given year, the Commonwealth would be able to draw a shortfall payment from a $150 million cash collateral—as well as a $50 million letter of credit, replenishable annually—provided by the private manager as a condition of the contract. Under state law, all net proceeds from the Pennsylvania Lottery are used to fund programs for seniors—including senior centers, in-home services, property tax and rent rebates, prescription drug assistance and long-term living services—which are likely to face rapidly growing funding pressures, as the Commonwealth’s senior population is projected to jump by nearly 1 million over the next two decades. State officials estimate that the PMA will generate an additional $3.0–$4.5 billion in new funding for senior programs over the 20-year term (relative to in-house operation), and minimize the historic volatility of lottery revenues.

Other key terms of the PMA include the following:

  • A 20-year base contract term, with a 10-year extension possible if performance warrants;
  • Ownership and control of the lottery are retained by the state, with most business responsibilities transitioned to the private manager;
  • A management fee for the private manager, with any additional incentive compensation capped at 5 percent of revenues;
  • Guaranteed positions in the state workforce for current lottery employees that choose not to transition over to the private manager; and
  • The use of industry best practices for responsible sales growth, including monitor-based games and Internet products.7

In early January 2013, the Corbett administration signed the contract with Camelot and sent it on to the state's attorney general for final review and approval. However, in February 2013 Pennsylvania Attorney General Kathleen Kane announced that she had rejected the agreement over concerns over its constitutionality and a lack of statutory authorization for an expanded set of gaming products. In response, Camelot agreed to extend the company's bid through June 2013, allowing time for the Corbett administration to renegotiate the contract to address Kane's concerns. At press time, negotiations were ongoing.

If the contract renegotiation is successful, implementation is unlikely to proceed until the courts rule on a lawsuit filed in December 2012 by the American Federation of State, County and Municipal Employees, the public employee union that represents state lottery employees, claiming the governor’s office lacked the statutory authority to enter into the contract and to allow the private manager to introduce keno and online games. Even as the union was suing the state, it also prepared a counterproposal claiming that current employees could outperform the private manager if lottery operations were kept in-house. However, the Corbett administration rejected the counteroffer, noting that it lacked any guarantee of new revenues or downside protections for the state, nor did it offer a credible plan to expand the player base.

New Jersey: In April 2013, New Jersey Governor Chris Christie's administration issued a notice of intent to award a 15-year contract to Northstar New Jersey Lottery Group to take over the marketing and sales functions of the New Jersey Lottery. Under the terms of the contract, Northstar will make an upfront payment of $120 million to the state upon the final award and execution of the contract, and it has committed to generating between $1.42 billion and $6.88 billion of additional net income for the State over the life of the contract, relative to what the state estimated would be generated through continued in-house operation. The initiative could also include the implementation of the first online lottery games in the state.

After launching the lottery procurement in August 2012, the state ultimately received one bid from Northstar, a joint venture of GTECH Corporation and Scientific Games—the team operating the Illinois Lottery—in partnership with a subsidiary of the Ontario Municipal Employees Retirement System, a large Canadian pension fund. Four vendors—GTECH, the Camelot Group, Scientific Games and Intralot—had demonstrated early interest in bidding, but two (Camelot and Intralot) dropped out as the procurement proceeded, and the other two firms opted to join forces on a final bid.

In a press release announcing the contract award, New Jersey Treasurer Andrew Sidamon-Eristoff noted that, “[t]he contract we plan to enter into with Northstar New Jersey protects [our] legacy commitment to New Jerseyans by positioning the Lottery for sustained growth and continued success in the face of an increasingly complex and competitive marketplace.”

Under the contract, Northstar will take over lottery marketing and sales functions, while security, licensing, auditing, and prize payment functions will be retained by the state.8 Current state lottery employees affected by the privatization will either be offered an interview with Northstar or will be transferred to other positions in state government.9

Legislative Democrats, concerned over potential union job losses, have taken an aggressive stance to combat the lottery contract. In March 2013, the state legislature approved a bill requiring legislative approval of the lottery contract, though observers expect Christie to veto the bill.10 Further, the Communication Workers of America—the union representing current lottery employees—has indicated that it may file a lawsuit to stop the contract from proceeding.

Ohio: The administration of Governor John Kasich continued to evaluate a potential PMA for the Ohio Lottery in 2012. A provision in the governor’s 2012–2013 budget proposal that would have authorized the privatization of lottery management was pulled late in negotiations amid legislator concerns. The administration has had an ongoing dialogue with potential bidders in 2012, though at press time it had not yet initiated a formal procurement. All net lottery proceeds to the state are dedicated to primary and secondary education.

» Return to Annual Privatization Report 2013: State Government Privatization
» Return to Annual Privatization Report 2013 homepage


Endnotes

1 Paul Merrion, "Illinois Lottery says private manager owes $20 million penalty," Crain's Chicago Business, March 15, 2013.

2 Monique Garcia, "Private firm running Illinois Lottery fined $20 million for falling short on sales," Chicago Tribune, March 18, 2013.

3 More information and supporting documentation are available on the Hoosier Lottery PMA homepage: http://www.hoosierlottery.com/about-us/bids/public-records

4 Eric Bradner, “Hoosier Lottery votes to hire private firm to run operations,” Evansville Courier & Press, October 3, 2012.

5 More information and supporting documentation is available on the Pennsylvania Department of Revenue's Lottery PMA homepage: http://www.revenue.state.pa.us/LotteryPMA

6 Leonard Gilroy, “Privatizing Lottery Management in Pennsylvania (Interview with Pete Tartline, Executive Deputy Secretary of the Budget, Commonwealth of Pennsylvania),” Reason Foundation, December 20, 2012, http://reason.org/news/show/pennsylvania-lottery-tartline (accessed December 21, 2012).

7 Pennsylvania Department of Revenue, “Pennsylvania Determines Key Terms of Potential Lottery Private Management Agreement,” press release, November 9, 2012, http://goo.gl/7dL4a (accessed November 9, 2012).

8 Matt Katz, "Christie privatizes lottery," Philadelphia Inquirer, April 12, 2013.

9 Ibid.

10 Associated Press, "NJ to award contract in lottery privatization," April 12, 2013.

Leonard Gilroy is Director of Government Reform





;