Is Vermont’s Lottery-leasing Scheme Too Risky? A Report from SUNY-Albany Runs the Numbers

No one consulted Alan Yandow before the announcement, last November, that Gov. Jim Douglas wanted to turn the Vermont Lottery [1] over to private investors.

As executive director of the lottery, Yandow might have had an opinion about whether it made sense to sell or lease the state’s numbers racket to the highest bidder. Even now, Yandow only knows the bare bones of the governor’s proposal ­— that privatizing the Vermont Lottery could be worth $56 million up-front to the state, plus $23 million a year, guaranteed, until roughly the middle of this century.

“It’s not something we’re a part of,” Yandow said the other day, before sitting down for the monthly meeting of the Vermont Lottery Commission. “We didn’t propose it. Now, we’re just waiting for more details.”

Vermont is one of a dozen states thinking about turning its gambling operations over to the private sector. The rationale for doing so runs from the moral (lotteries are an unseemly source of government revenue) to the practical (business would do it more profitably).

The real reason is that auctioning off the lottery is an expedient way to collect revenue the state has yet to earn. In keeping with the fiscal aims of other states considering privatization, Douglas proposes to split Vermont’s $56 million windfall between school construction projects and property tax rebates.

But, aside from the short-term upside of good intention, would selling or leasing the state lottery make financial sense over the long haul?

Bob Purtell and James Fossett, professors at SUNY-Albany’s Rockefeller College of Public Administration and Policy [2], took up the question recently by analyzing privatization proposals in six states — California, Michigan, Illinois, Texas, Colorado and Indiana. The data for the study, entitled “Hey You Never Know: Selling State Lotteries in America,” predates the announcement of Douglas’ plan, so the 40-year lease option that Lehman Brothers put before the governor in December wasn’t one of those evaluated by Purtell and Fossett.

But Purtell, a Wall Street retiree and former Vermonter, said the questions he and Fossett raise can be applied to any sale or lease proposal — and, perhaps, should be.

“We’re trying to give people a thought process, a guideline,” he says. “We’re trying to give people a way to think about it so they are less likely to make a bad decision.”

In their report, Purtell and Fossett say that states thinking of privatizing their lotteries face a “classic Catch-22.” To attract investors, a lottery must demonstrate strong historical growth and the potential for future growth. That means the more attractive a lottery is to private investors, the more the state has to lose: the compounded growth in lottery revenues may be larger than the return on investment of the proceeds from the sale or lease.

“If you sell the lottery,” Purtell says, “you’re giving up all the growth.”

At best, selling and leasing state lotteries makes “short- to medium-term sense,” Purtell and Fossett conclude. In Colorado, for example, the state projects the lottery will grow 2.2 percent per year. If the state were to go the privatization route, and invest the proceeds in U.S. Government securities, Purtell and Fossett predict Colorado could lose out on $22.7 million in the first year of the lease alone; by the same calculation, the shortfall would reach $87.5 million by the 20th year. Even high-yield bonds would fail to generate returns that would outpace the future revenues generated by the lottery’s growth.

“To the extent that politicians are content with a two- to 18-year time horizon of benefits,” Purtell says, “this might make sense to them.”

Moreover, Purtell predicts, private operators will likely insist on more aggressive investment strategies, something the states might be hard-pressed to prohibit over the course of a 40-year lease. “If you give control of the lottery to a private operator, that private operator is likely to take a fair amount of risk with the investment assets,” he says. “I would if I were a private operator, because if they get in trouble, the state’s going to have to bail ’em out because the state is not going to let its lottery go south.”

A good part of “Hey What Do You Know” addresses familiar arguments in support of lottery privatization, such as the belief that private companies are more efficient than government-run enterprises. Purtell and Fossett point out that lotteries are “virtual businesses,” with relatively few employees. They rely on external service providers for their technological needs and to develop new games. “The vast majority” of a lottery’s assets are earmarked for payouts to winners. Lotteries are, therefore, inherently efficient, and the potential savings from cutting costs would be small.

At roughly 6.5 percent of revenue, Vermont’s 2006 operating costs were slightly higher than those in the six states Purtell and Fossett examined. But they didn’t see much room for improvement: “I don’t know how you squeeze much more out of it,” Purtell says.

Finally, the Albany analysis urges caution before states sell their lotteries in order to avoid “difficult and politically unpopular” decisions down the line. Especially in states like Vermont, where lottery proceeds go to K-12 education, proceeds from privatization may not keep apace with funding demand. Such states may, at some point, be forced to raise property taxes, “adding to the disparities lotteries were originally designed to mitigate.”

“The ‘gold towns’ won’t have any problem,” Purtell explains. “But the tax-importing towns are going to find themselves with, maybe not a lot, but some amount less money every year. Their choices are to raise taxes or short-sheet the education system.”

That irony wouldn’t be lost on Alan Yandow. During last week’s meeting of the Vermont Lottery Commission, Yandow offered the briefest of updates on Douglas’ privatization scheme. He told commission members he had recently gone before a couple of legislative committees, including House Ways and Means, but that additional information was scarce. “There’s not much definition beyond what the Lehman Brothers proposal presents,” he reported.

According to Lehman, the Vermont Lottery has enjoyed an average 13 percent annual growth in the last 20 years, but profits have declined in six of the last nine; adjusted for inflation, profits are off 20 percent since 1996. Still, Lehman reckons a lease of the Vermont Lottery would fetch between $260 million and $380 million at auction.

The lower figure assumes the new operator launches no new games or marketing campaigns. The $260 million would come in a lump sum, used to purchase an annuity that would pay out $20 million to the state. If the Vermont Lottery goes for $380 million, that would lock in 2006 revenues, $23 million, for 40 years and net $56 million up-front. That figure assumes that a private operator would make Vermont “a top performer in each game category” by launching a more aggressive sales strategy and constantly developing new games and features to maintain interest. Per capita ticket sales would increase from $168 to more than $220 under that scenario, and the lottery would grow about 3.5 percent for the first 10 years. After that, annual growth would be 0.5 percent.

After the commission meeting, seated at a paper-laden conference table in his office, Yandow said he was surprised when Douglas announced that he thought a private contractor could squeeze more revenue out of the lottery.

“Even the Lehman report said the Vermont Lottery has been well run,” Yandow said. “We’re restricted in what we can do.”

The lottery routinely pays out more than 60 percent of its revenues in prizes each year. Its retail penetration — one ticket outlet for every 867 people — ranks first among the country’s 42 state lotteries. At $168, per capita sales rank 18th (Massachusetts residents spend a whopping $700 a year on the lottery). But Yandow believes that’s a reflection of the success of the commission’s “Please Play Responsibly” campaign.

Yandow, echoing Purtell and Fossett, suggested that leasing the Vermont Lottery is not merely a financial matter but a public policy issue that deserves careful consideration.

“What do they want the lottery to do?” Yandow asked. “And how do they ultimately want the lottery to grow?