In 2011, Illinois became the first state to privatize the management of its lottery in return for a commitment from the private manager to increase net lottery revenues, a groundbreaking deal that has prompted officials in other states to pursue similar initiatives in 2012. Officials in Indiana approved a similar private management agreement (PMA) in the fall of 2012, and governors in Pennsylvania and New Jersey launched lottery PMA procurements that year as well.
In November 2012, the Commonwealth of Pennsylvania 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 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.
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 provided by the private manager as a condition of the contract, if ultimately executed. Under state law, all net proceeds from the Pennsylvania Lottery are used to fund programs for seniors, which include senior centers, in-home services, property tax and rent rebates, prescription drug assistance and long-term living services.
In December 2012, Reason Foundation Director of Government Reform Leonard Gilroy interviewed Pete Tartline, Pennsylvania’s Executive Deputy Secretary of the Budget-the chief financial officer of the Commonwealth-on the proposed lottery PMA, how it compares to similar deals in other states, the recent pushback by public employee unions and more.
Leonard Gilroy, Reason Foundation: Governor Corbett has demonstrated a keen interest in privatization and public-private partnerships (PPP), creating a privatization and innovation council, signing transportation PPP-enabling legislation and exploring several opportunities to leverage state assets and private investment in the Commonwealth, including most recently the proposed PPP for state lottery operations. Why has Gov. Corbett decided to explore a private management agreement (PMA) for the state’s lottery?
Pete Tartline, Executive Deputy Secretary of the Budget, Commonwealth of Pennsylvania: In September 2011, the Governor created a Council on Privatization and Innovation, which examined a number of government operations and made recommendations to the Governor on potential privatization options. Given the challenge of funding senior programs in the coming decades, earlier this year the Council identified private lottery management as a potential opportunity to increase the revenue generated and provide a stable and predictable revenue resource for the Commonwealth’s senior programs.
In Pennsylvania, 100 percent of lottery proceeds go to support programs for older Pennsylvanians, and in most cases, the senior programs are almost entirely supported by lottery revenues. Pennsylvania is looking at the population of 60 and older growing by roughly 900,000 over the next couple of decades. We rank fourth nationally in terms of our percentage of older residents, with 2.7 million residents over the age of 60. And by 2030, nearly a quarter of our population is going to be 60 and older. The population of those 80 and older is growing even more rapidly than that.
Given that most states obviously have challenges on the general fund side, we’re not going to be able to increase funding for nearly any program, so the question for us becomes how do we grow lottery revenues to keep up with the demand for senior programs, things like property tax and rent rebates, low cost prescription drugs, transportation services and long-term living services? These are the kinds of things we’re going to see increased demand for in the coming years, so we want to create a growing, stable and predictable revenue source to support those programs, given the demographic shifts that Pennsylvania is facing. We believe that the lottery PMA offers a solution.
Gilroy: The position of the Corbett administration is that it has the authority to move forward with a lottery PMA without seeking legislative approval, a position that opponents have challenged. Can you describe the Administration’s authority to move forward with a PMA? How has the Administration worked to inform the legislature during the process?
Tartline: The statute creating the Pennsylvania Lottery provides the Secretary of Revenue very broad authority to manage and operate the lottery, and to do so in an effective and efficient manner. This is the authority guiding the PMA.
And we have other significant, existing contracts as well at the lottery that did not require legislative approval. In fact, with the lottery’s current contract with Scientific Games to manage instant and terminal-based games, their compensation is likely greater than what a private manager’s would be under the PMA.
With regard to the legislature, a day or two after the request for qualifications was issued, the Secretary of Revenue, the Secretary of Aging and the director of the Pennsylvania Lottery testified at a House Aging Committee hearing to outline the process-the rationale, the reasons why we’re undertaking the initiative.
Since then, there have been over 100 meetings and conference calls with legislators and staff at significant milestones throughout the process. We’ve also had a number of leadership discussions, keeping them updated on the process, while also recognizing that it is a government procurement and all information is not made available in order to maintain the integrity of the procurement process. Additionally, the Commonwealth has provided updates to the public along the way, primarily through press releases, online resources (www.revenue.state.pa.us/LotteryPMA) and updates to lottery employees, stakeholders and groups within the senior community.
Gilroy: The lottery operator Camelot has offered the Commonwealth nearly $34 billion in guaranteed payments over the next 20 years. How has the lottery performed historically under public sector management? What do you know about the bidder’s experience in managing lotteries?
Tartline: We’re coming off of a historic level of performance, with an 8.4 percent increase in revenue and 4.4 percent increase in profits last year. But over the last five years the 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. I should add that $34 billion is probably an underestimate because actual performance over the second ten years of the contract would probably be greater than the minimum we required from bidders. If you look at the structure of the contract, the incentives are aligned-the bid is realistic, but yet the contractor has the incentive to exceed their commitment-so the incentives of the Commonwealth and the bidder are aligned to maximize revenue for the benefit of our senior programs.
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.
And Camelot is experienced. They manage a $9 billion lottery in the United Kingdom, they have global experience managing lotteries, and they have consulted in the United States as well. While Pennsylvania regards its lottery very highly, Camelot also has a very strong reputation globally.
Gilroy: The Administration refers to the PMA as a “Perform or Pay” contract structure. Can you talk further about the incentives and penalties that are embedded and how this differs from the other lottery management contracts we’ve seen in the U.S. to date?
Tartline: The private manager is agreeing to a 20-year profit commitment, which allows us to budget for senior programs. The bidder will put up $150 million in cash collateral in a restricted lottery account that the Commonwealth can draw on if they don’t meet that commitment. And if that collateral is drawn down to $50 million there’s a springing letter of credit that is replenishable and grows as profit grows. So they’re putting over $200 million at risk if they don’t hit their commitments.
They earn incentive compensation if they achieve profit above their commitments, and the Commonwealth and the bidder will share in that profit. The incentive is to bid realistically and exceed their commitment.
The other incentive in the contract is that if they hit their profit commitments in the first five years, then for each year they hit their commitment they will get an automatic contract extension at the backend. So it’s a 20-year term for the contract, and if they hit their commitments in the first five years they get a five-year contract extension. Additionally, if they hit their commitments in years six through 15, then they will get another five-year extension.
If you’re looking at long-term growth and revenue, then the incentives are for them to hit their profit commitments in the early years and perform to get their contract extensions at the end of the contract. All of the incentives are aligned for the bidder and the Commonwealth to achieve the desired revenue commitment, and even to exceed it so that the bidder can earn incentive compensation.
Our PMA structure is different than in other states, because I don’t believe that Illinois or Indiana have the same kind of upfront cash collateral required for downside protection. And I don’t believe that other states have created the same incentive structure for contract extensions, although Indiana has some provision for extensions as well.
We believe that the bidding structure that we created made for a more realistic bid than perhaps was the case in Illinois, though our incentive structure is a shared benefit similar to Illinois. The thing that would differentiate our PMA would be that the downside protection is greater, and we’ve limited the ability of the bidder to challenge the profit commitment based on the tight adverse action language that’s in the contract. This should mitigate the issue seen recently in Illinois, where there has been tension between the state and manager. Also in the Pennsylvania PMA, the annual profit commitments are structured to provide maximum revenue security and stability for seniors.
Gilroy: Two potential bidders dropped out of the competitive procurement along the way. Do you think some of the downside protection in the PMA-e.g., significant financial risks transferred from the state to the private lottery manager-could explain why the Commonwealth got one bid in the end?
Tartline: It is very likely that certain bidders were not willing to absorb some of the risk that the PMA would require. It might not just be the $150 million cash collateral, but also the adverse action provisions that we included in the agreement as well. There were risks that some managers were not willing to take.
Gilroy: In Pennsylvania, under state law the public employee union currently providing a service has an opportunity to make a counteroffer after the winning private bidder is selected to see if they can do better. However, the union representing current lottery employees (American Federation of State, Council and Municipal Employees Council 13) has taken a position strongly opposing the proposed PMA. Can you please clarify what would happen to lottery employees if a PMA is ultimately executed?
Tartline: The way the PMA is designed, the operations that would remain with the Commonwealth would include things like quality control, security, drawings, audits, licensing-those kinds of controls would remain with the Commonwealth. Approximately 70 current employees would remain with the Commonwealth, while other employees in areas like marketing and retailer relationship management would be transitioned to the private manager. The agreement also requires an employee transition plan, and we would require the private manager to interview and consider all current lottery employees as potential candidates. Though they would not be required to hire them, the bidder has given us indication that they would be interested in all of our employees and would likely hire most, if not all, of them. They would also expand employment over time.
AFSCME is the union that represents most lottery employees. Anytime the Commonwealth will privatize, contract out, or outsource an operation, it’s defined in Article 43 of the master collective bargaining agreement that there’s a required “meet and discuss” period, there’s a requirement that contract terms and other information is shared with the union, and then they have a certain number of days to provide a counteroffer to the Commonwealth.
In most cases, an outsourcing is intended to create efficiencies or save money, so the unions have an opportunity to come up with other ways to achieve those goals that might not result in the furloughing of public employees. In this case the dynamics are a little bit different as the focus is “improved delivery of service,” but they still have the opportunity to make a counteroffer.
The only ones who have something to lose under the PMA would be AFSCME itself-not the employees-so they are fully mobilized to challenge the PMA. We’ve recently seen them challenge the PMA through billboards, lawsuits and grievances, for example. Yet we have followed every requirement in Pennsylvania’s procurement code, we’ve met every requirement in the master agreement, and we are pursuing this for the right reason, which is to provide more revenue for senior programs.
Gilroy: Overall, what is the value proposition for private lottery management, both for the Commonwealth and its taxpayers?
Tartline: The potential is to provide an increasing, stable, and predictable revenue source to support programs for older Pennsylvanians, which will likely ease pressure on state funding. We don’t know what’s going to happen with federal funding for programs for older Americans, so this is an opportunity to provide some stability and security for programs that support seniors in Pennsylvania. The process itself has been a rigorous and thoughtful procurement over the course of the last nine months, and we believe that the results would benefit the Commonwealth, its taxpayers and its senior population.
Pete Tartline was appointed Executive Deputy Secretary of the Commonwealth of Pennsylvania’s Office of the Budget effective January 19, 2011. The Executive Deputy Secretary of the Budget serves as the chief financial officer of the Commonwealth and oversees finance-related aspects of government administration. The Executive Deputy Secretary also oversees the preparation and monitoring of the Commonwealth’s budget, including the maintenance and improvement of the Commonwealth’s performance measurement system.
Prior to his appointment as Executive Deputy Secretary, Tartline managed an independent consultant operation focusing on business performance improvement providing continuous improvement facilitation to various clients in a number of business sectors. Before that, Tartline served as President and CEO of the Technology Council of Central Pennsylvania.
Tartline’s previous Commonwealth government service was as Deputy Secretary for Administration at PennDOT from 1999 to 2003 and as Deputy Director of the Governor’s Policy Office from 1995-1999. Tartline also served in the Office of U.S. Congressman Bill Goodling from 1988 to 1995, leaving his position as Chief of Staff to join the Ridge Administration in 1995.
Tartline holds a B.A. from Gettysburg College and M.Ed. from George Mason University along with certificates in Human Performance Improvement (Penn State University) and Program for Senior Executives in State and Local Government (Harvard John F. Kennedy School of Government).
Other articles in Reason Foundation’s Innovators in Action 2012 series are available online here.