National Council of Legislators from Gaming States Committee on Lotteries

1. Update on Private Lottery Management Initiatives National Council of Legislators from Gaming States Committee on Lotteries 2014 Winter Meeting – Hollywood, FL January 10, 2014 Leonard Gilroy Director of Government Reform Reason Foundation

2. Understanding “privatization” • Ongoing fiscal pressures have prompted state and local governments to seek new or expanded opportunities to tap the private sector to lower costs and/or increase revenues. • “Privatization” is simply an arrangement between governments and private sector to deliver public services & assets. • e.g., public-private partnerships (PPPs), outsourcing, contracting out, competitive sourcing, etc. • Can range from simple service contracts to large-scale asset sales and joint ventures. • Now a proven policy management tool—BUT, process is complex, requires care & best practices. • Introduces competition; promotes innovation, efficiency in serving both the public interest & the shifting demands of customers.

3. “Privatization” in the lottery context • All 44 states that operate lotteries currently outsource certain components of their internal lottery operations. • The privatization question isn’t “if,” but “to what extent”? • Two basic types: • Facilities management: 41 states outsource a mix of products, central data systems, technology, software, hardware. • Private management agreements (PMA): facilities management services + financial commitments, marketing, sales force, game development. • PMAs now active in Illinois (2011), Indiana (2013) and New Jersey (2013). • Pennsylvania recently ended PMA procurement, but may revisit. • Third “in-between” category emerging: facilities management w/ additional outsourcing (TX, NE, NY, WV) = facilities + sales force.

4. PMAs simply dial up the scope of outsourced services • Central data systems • Lottery terminals • Instant ticket printing/distribution • Vending machines • Advertising • Sales force • Financial commitments • Marketing • Game development • Central data systems • Lottery terminals • Instant ticket printing/distribution • Vending machines • Advertising • Sales force • Central data systems • Lottery terminals • Instant ticket printing/distribution • Vending machines • Advertising Private Management Agreements Facilities Management Facilities Management Plus+

5. Understanding PMAs • PMA model gives private manager more responsibility in exchange for revenue enhancement guarantees. • Reduced revenue volatility & more predictability. • PMAs designed to deliver better returns to the state: • Private operator has incentive—subject to state oversight—to grow the business to increase net revenues, via new product lines, improved marketing, new outlets. • Private operator in a better position to maximize revenues—not constrained by budget cuts, civil service laws limiting incentive pay & bonuses for sales force. • State retains control and remains the regulator: • Retains control over all significant business decisions, approves annual business plans. • State continues to manage security, financial procedures, legal, accounting, auditing, retail licensing, prize claim verification.

6. Understanding PMAs • Risk transfer: State can hold private manager accountable for meeting financial, compliance, staffing, subcontracting & environmental commitments, transferring major risks. • Private manager typically offers positions to in-house workers and hires additional employees—growing the business to increase revenue. • Private manager is typically in a better position to bring cutting edge technology, in addition to world class advertising, marketing, game development, retail recruitment, and point-of-sale execution. • Opportunity to enhance social responsibility: • Indiana PMA requires manager to achieve World Lottery Association certification, meet global standards on social responsibility, transparency, and third-party independent accountability.

7. PMA case study: Illinois • Illinois signed 10-year PMA with Northstar Lottery Group in 2010. • Designed to generate $1.1B in net new revenue over first 5 years, relative to state operation. • State approves annual business plans; retains access to operations info. • Northstar receives $15M annual management fee, eligible for incentive pay (subject to 5% total net income cap). • Penalties assessed if manager fails to hit annual revenue targets. • Northstar retained (and manages) state employees & added private staff. • Two straight years of record revenues after years of flat revenues; record number of players and retailers. • Revenues up over $100M/yr relative to state operation. • Now among states with fastest growing lottery revenues. • However, manager hasn’t reached net revenue targets, leading to assessed penalties and disputes over state actions that adversely impacted ability to reach targets.

8. PMA case study: Indiana • Indiana signed 15-year PMA with GTECH Indiana in 2012. • Designed to generate $500M in additional net income over first 5 years, relative to state operation. • Additional $2.1B over all 15 years. • Increased Hoosier Lottery’s use of contracted services from 88% to 95% of total operations. • Manager required to attain World Lottery Association certification. • Indianapolis Star (Dec 2013) reports lottery ticket sales up 17% in first 6 months of PMA; revenues running at 96% of target level. • New games on deck for 2014. • Former Gov. 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.”

9. PMA case study: New Jersey • New Jersey signed 15-year PMA with Northstar New Jersey in 2013. • Designed to generate a minimum of $1.4B in additional net income over life of contract, relative to state operation. • Also included $120M upfront payment to state. • Northstar took over marketing & sales functions in Oct 2013; state retains control over security, oversight, licensing, auditing, prize payments. • Northstar eligible for incentive pay (subject to 5% total net income cap). • Penalties assessed if manager fails to hit annual revenue targets (capped at 2% of annual net lottery income). • Northstar hired on former state employees & is growing sales & marketing staff. • Gov. Chris Christie: “We are outsourcing the management and marketing of the lottery […] The state still owns the lottery. The state still gets the income stream from the lottery.”

10. Some lessons learned • Complexity demands due diligence. • Hire outside legal & financial consultants to evaluate, structure deals. • Clarity & transparency in accounting of revenues & targets is critical. • Deals are not cookie-cutter, so customize. • State should determine goals and desired outcomes, then build procurement/contract to achieve them. • Transitions are always tricky, so prepare. • Shift from direct operation to serving as regulator of outside manager brings major organizational change, shifts responsibilities. • Client-vendor communication, relationship is key to success. • Unforeseen circumstances inevitably arise, be ready to adapt. Clear expectations, open communications, and flexibility are critical to success. • Leverage the procurement moment for potential transformation. • Can use routine procurements to test market for PMA-style concepts.

11. Questions? Leonard Gilroy Director of Government Reform Reason Foundation leonard.gilroy@reason.org (713) 927-8777 reason.org