Commentary

Illinois vs. Indiana: A Tale of Two Privatized Lotteries

Differing experiences show importance of client-vendor relationships

Illinois and Indiana are two states that have turned to private management of their lotteries in recent years in an attempt to generate higher net revenues to the state (see here for background). This month brought news that the experiences of these two states could not be more different. While Illinois announced plans to cancel its lottery contract after the private manager missed its revenue targets for the third straight year, Indiana officials reported that their private manager came in just shy of its revenue target and hit historic levels of revenue growth. What do these disparate experiences tell us about the early experience with private lottery management?

The answer is that, like any privatization initiative, context and client-vendor relationships matter.

In Illinois’ case, the client-vendor relationship seemed to be on shaky ground almost from the beginning of the contract in 2011. As the Chicago Business Journal and Crain’s Chicago Business recently reported, the relationship between the state and Northstar Lottery Group-a partnership led by GTECH and Scientific Games-began to sour in the first year of the contract after the appointment of a new state lottery director who, among other things, happened to be part of a competing consortium that lost out to Northstar in the original procurement for the lottery contract and took various actions to reverse or block some of Northstar’s business decisions after taking office.*

The lottery director also actively advised other states not to follow Illinois’ path to private lottery management as far back as 2012, which probably didn’t help the relationship.*

Further, there’s never been a clear picture of how Northstar actually performed in Illinois, as the two parties have never agreed on annual revenue figures since the beginning, and they remain an ongoing subject of arbitration. Another source of tension has been Northstar’s unsuccessful pursuit of changes to the targets agreed to in the original contract to reflect what it saw as certain state actions that limited its ability to execute parts of its annual business plans.

Last, the Illinois contract contained an element that created an inherently challenging management situation: sales representatives that worked for the state prior to the contract remained state employees but were managed by Northstar. While this may have been an attempt to minimize union opposition and simplify the transition from a human resources perspective, from a management perspective there is always going to be a limit in terms of how much discretion and control a private company has over the part of the workforce it doesn’t directly employ. That will affect a range of issues from incentive pay to workplace rules and more.

Given the acrimony and the sensationalist headlines of “mismanagement,” it’s easy to lose sight of the fact that while Northstar may not have hit its ambitious revenue targets for various reasons, it consistently brought in more net revenue to the state in each of the last three years relative to what the lottery had returned when it was under state management. Earlier this summer, a Northstar official told the state’s Lottery Control Board that net revenues to the state had increased by approximately $450 million since the contract began in 2011, representing a 12 percent annual growth in sales (compared to three percent under state operation).

In short, the real story in Illinois is that private management achieved the fundamental goal of increasing net lottery proceeds, outperforming in-house operation. All of the remaining conflict and contention revolve around the issue of by how much private lottery management was beating in-house state operation.

While it’s earlier in the process, the situation in Indiana seems to be yielding a similar result-record revenues-without the client-vendor tensions seen in Illinois. According to The Indianapolis Star, GTECH-the Hoosier Lottery’s private manager, and part of the Northstar consortium in Illinois-delivered nearly $251 million in net revenues to the state in its first year of a 15-year contract, which represents a 12 percent increase over the $224 million delivered to the state under its last year of in-house operation. Gross revenues were up nine percent to over $1 billion relative to the high achieved under state operation.

Nonetheless, private operator GTECH came in just shy of hitting its first year target-by a margin of less than one percent-and it made a $1.6 million payment to the state to cover the difference. But this appears to have occurred without the sorts of fingerpointing, arbitration, contract disputes and other drama that we saw in Illinois.

This is a critical point. In these lottery private management agreements, the private manager transfers revenue risk away from the state by agreeing to make the state whole if they don’t meet their annual net revenue targets. This process appears to have played out well in Indiana, where GTECH made up that difference. By contrast, even though Northstar has made approximately $60 million in shortfall penalty payments to Illinois thus far, the full penalty process has never really played out because the two parties have been locked in lawsuits and arbitration since 2012 on what the annual revenue targets should be, as well as what the final annual revenues have actually been in each of the three years of the contract. In short, the penalty process has never had a chance to fully work in Illinois, and thus the state has not been able to reap the benefits of transferring the risk of revenue underperformance to the private manager. It is disingenuous to complain about underperformance when the contract mechanism designed to mitigate the potential effects of underperformance is not given the chance to work.

By contrast, the chairman of Indiana’s state lottery commission recently told The Times, “I consider this first year to be a huge success. […] This contract, from my perspective, worked exactly as it was supposed to work.” In the same article, Hoosier Lottery executive director Sarah Taylor noted that Indiana learned some lessons from the Illinois experience as they developed their initiative-presumably covering some of the more contentious issues in Illinois like revenue determination, dispute resolution processes, employee transitions and the like-and expressed satisfaction with the agreement and the first-year results. This is obviously a stark contrast from the tone in neighboring Illinois.

While it’s still early-and Illinois has not yet announced how it intends to unwind the Northstar contract and move forward-two simple lessons are obvious that apply to any type of long-term contract between the public and private sectors. First, communication between the client and vendor is essential in situations involving major transitions from government operation to private management, and there needs to be trust between the parties and ways to collaboratively solve disputes. Second, clear expectations shared by both parties are critical to success. It is possible-even likely-that conditions may change after a contract is signed, and there needs to be a fair, transparent and non-contentious pathway established from the beginning to make adjustments mid-course.

Illinois presents a situation in which the shared expectations at the beginning of the contract changed quickly, yet there was an inability to come to a mutual agreement on how the partnership should reflect those changes. There may be a temptation to assume that the privatization of lottery management “failed” in Illinois, but it would be mistaken-what failed was the client-vendor relationship the privatization was built on. Luckily, Indiana seems to have learned from Illinois’ experience and built an initiative on a more solid foundation.

Leonard Gilroy is director of government reform at Reason Foundation and is the editor of the Privatization & Government Reform Newsletter, available here. This article was featured in the August 2014 edition of the newsletter.

* UPDATE (8/29/2014): After this article was published, Illinois Lottery Director Michael Jones sent communication to correct my summary of the linked articles, noting that: “I was never a part of a competing consortium which lost out to Northstar. There were only two bidders for the Illinois Private Manager opportunity: Northstar, a partnership between the lottery’s existing vendors, and Camelot, the UK’s private manager. My group refused to submit a bid and did not participate at all.”

In addition, Jones stated that he “never actively, nor inactively, advised states not to seek a private manager for their lotteries” and that he “merely answered a reporter’s questions.” In retrospect, my semantic choice of the phrase “also actively advised other states not to follow Illinois’ path” was imprecise. Instead, it would have been more technically accurate to say that the director “was quoted in the media warning that other states should not follow Illinois’ path.”

Leonard Gilroy is vice president of government reform at Reason Foundation, a nonprofit think tank advancing free minds and free markets. He also serves as senior managing director of the Pension Integrity Project at Reason Foundation, which assists policymakers and other stakeholders in designing, analyzing and implementing public sector pension reforms.