J.

OF PUBLIC BUDGETING, ACCOUNTING & FINANCIAL MANAGEMENT, 22 (3), 376-406

FALL 2010

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

Robert M. Purtell and James W. Fossett*
ABSTRACT. Several US states are exploring selling or leasing lotteries to
private operators to plug budget gaps and fund new priorities. Given the
long-term implications, governors, budget officials and legislators need a
framework for analyzing lottery-sales decisions. This paper presents such a
framework and illustrates it by estimating likely privatization-proceeds and
post-sale cash-flows for six states. Our findings are decidedly mixed. We
found pricing expectations reasonable for three states and high for three
others. However, even at expected pricing levels, sales or leases make, at
best, short- to medium-term financial sense. That does not mean states
cannot make use of financial markets and private-public partnerships. We
offer structural and contracting options that provide a middle ground for
policy makers as they consider increasing lottery proceeds or accelerating
collections.
INTRODUCTION

Privatization has assumed growing importance as a public

management tool. Proponents argue that privatization improves
service quality, allows government to leverage resources, leads to
increased efficiency and allows governments to increase revenues
while reducing operating risks.
----------------------------* Robert M. Purtell, Ph.D., is an Assistant Professor and the Director of the
MPA Program, Department of Public Administration, University at Albany of
the State University of New York. His research and teaching interests focus
on managerial- and market-finance issues facing public and nonprofit
managers. James W. Fossett, Ph.D., is an Associate Professor, Department
of Public Administration, University at Albany of the State University of New
York. He has written extensively about state health policy and public
budgeting and finance.

Copyright 2010 by PrAcademics Press

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

377

As part of this trend, several US states have been exploring the

feasibility of selling or leasing their lotteries to private operators.
These governments already contract with for-profit lotterymanagement companies for a variety of management services, so
that privatization might be viewed as a next natural step. Elected
officials have also claimed that lottery sales or leases will generate
significant financial gains for state governments (Halper, 2007;
Shields, 2007). With state governments facing increasing fiscal
stress, consideration of state-lottery sales are politically attractive
alternatives to tax increases or service cuts. States may also look at
lottery privatization as a way to protect themselves from the
possibility of future revenue declines. They are worried about
sustaining their success in an increasingly competitive environment
in which customers have access to a wide variety of gaming
alternatives ranging from river boats to Indian casinos to Internet
gambling (Reynolds, 2007).
In this environment, governors, budget officials and legislators
need a framework for analyzing decisions about lottery sales. This
paper presents such a framework and estimates the range of likely
privatization-proceeds and post-sale cash-flows for six states that
have recently explored privatizing their lotteries. We combine widelyused valuation models with available reinvestment options and ask
whether lottery sales make fiscal sense. Can states sell their lotteries,
invest the proceeds in relatively-safe market instruments with
stable, predictable returns and generate the long-term funding they
need to continue to pay for earmarked public programs and, perhaps,
do a bit more?
Our findings are distinctly mixed. Based on historical growth rates,
we found state pricing expectations to be within reasonable valuation
ranges for three states1--California, Indiana, and Michiganand
outside these ranges for three others--Illinois, Texas, and Colorado. In
those states, desired pricing is achievable only if buyers believe that
they can grow lottery proceeds well above the historical rates of
growth we estimated.
In privatizing their lotteries the states will be consciously trading
off growing streams of lottery proceeds for fixed streams of post-sale
income. That is the catch twenty-two in these proposals. Higher
growth means higher privatization proceeds and higher post-sale
income. But it also means that governments will be forfeiting future

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compounded growth in lottery revenues that may be larger than what

they can attain by investing the proceeds of lottery sales.
Our findings suggest that lottery sales or leases make, at best,
short- to medium-term financial sense. For those states with
favorable valuations, post-privatization investment earnings fall short
of projected lottery proceeds within at most two to eighteen years of
privatization, depending on post-privatization returns. Given the
traditionally short-term perspective inherent in the political process,
elected officials might find that acceptable. Under some
circumstances, privatization may allow governments to, at least
temporarily, increase funding for earmarked programs, generate
funds for new priorities, stabilize funding levels at a predictable level
and transfer the operating risk of their lotteries to private operators.
However, neither lottery sales nor leases appear to generate
sustainable financial benefits.
Two factors have emerged in recent months that have
complicated lottery-privatization initiatives. First, the Office of Legal
Council in the Department of Justice (OLC, 2008) issued a legal
opinion stating that lottery leases were not permissible. However, as
we discuss later, OLC opinions do not have the force of law and might
be rejected by courts if states could challenge them successfully.
Second, the recession and resultant collapse in leveraged finance
markets have made it increasingly more difficult for for-profit
acquirers to finance large leveraged acquisitions of privatized assets.
However, the issue of leveraging lottery assets is clearly not dead. If
the current recession continues and governments broaden their
search for alternative sources of funding, lottery privatizations or
some of the alternatives we suggest later are likely to resurface.
None of these developments mean that states cannot take
advantage of the potential that more aggressive use of financial
markets and private-public partnerships might offer. We consider that
possibility and offer structural and contracting options that might
provide a middle ground for policy makers as they consider
alternative ways of increasing lottery proceeds or accelerating their
collection.

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

379

LOTTERY SALES AS PRIVATIZATION: PRO AND CON

There has been little experience and less scholarly attention to

public-asset sales in the American context, where privatization
discussions have more typically focused on the use of nongovernmental agencies to deliver public services. Governments have
occasionally sold assets such as toll roads or power authorities, but
these transactions have received little, if any, systematic attention.
Public-asset sales have been more common overseas, particularly in
countries where formerly socialist states have divested themselves of
a variety of industrial enterprises. Not surprisingly, given the
significant structural differences between lotteries and the production
enterprises that have been privatized overseas, the experience of
public-asset sales in other countries is of limited utility in judging the
value of lottery sales. In their review of privatization research, for
example, Megginson and Netter (2001)2 observed that many
governments have used privatization to preserve capital by reducing
public operating subsidies and opening access to capital markets for
newly privatized companies to fund growth. This argument is
unpersuasive as a rationale for selling American lotteries. Unlike
typical privatization candidates elsewhere like power authorities or
phone companies, lotteries are not industrial enterprises that
produce goods or services. Instead, they are gambling enterprises
which require neither large capital investments nor dependence on
public operating subsidies. Rather, lotteries generate profits virtually
from their inception. In the first partial year of operation of the Texas
Lottery, for example, the state generated nearly $592 million in gross
revenues with profits of $203 million. Within three years, Texas
Lottery revenues topped $3 billion and profits exceeded $927 million
(Texas Lottery Audited Comprehensive Annual Financial Reports,
2008)
The independence of lotteries from capital markets comes from
the business nature of lotteries and the operating structure that most
states have adopted. Lotteries are essentially virtual businesses.
Most have few employees and rely on outside service suppliers for
the bulk of their staffing and technological needs. Lottery agencies
themselves do not generally invest in systems or perform the
research and development necessary to develop new games. Instead
they rely on a cadre of external service suppliers to meet those
needs.3 State lotteries benefit either from supplier economies of
scale, expertise and self interest by relying on competitive bidding to

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PURTELL & FOSSETT

force these suppliers to share those economies with the states. In

effect, states substitute supplier relationships for the need to access
capital markets to fuel development, innovation and growth. The
ability of these suppliers to service multiple states also serves to
mitigate the well-known problem of supplier underinvestment in
specialized assets (c.f. Williamson, 1979). Because service suppliers
can spread asset-specific risk over multiple-state service-contracts,
they are able to diversify their investment risk thus mitigating the
chance that a single customer may shirk on its contractual
obligations or offer contract durations that are too short for the
suppliers to recover their investments. In addition, the existence of
multiple lottery-services suppliers and the free dissemination of
lottery operating statistics act to maintain a competitive market while
reducing the suppliers ability to take advantage of information
asymmetries with respect to service pricing.
Purchasing select lottery-service components from private firms
also makes it possible for governments to limit contracting to areas
where they can clearly define their objectives, like minimizing unit
processing costs, while retaining control over game structure,
marketing strategy, social-welfare implications and the dispersion of
funds where goals are harder to specify and monitor.
A second version of this argument is that privatization may free
up cash that governments have invested in capital assets (Young,
2007). In the case of lotteries, there are few such assets for
governments to reclaim. Table 1 displays the asset structure of the
lotteries in the six states of interest here.4 The vast majority of statelottery assets represent restricted investments set aside to pay the
future claims of past winners which cannot be liquidated.
Investments in capital assets net of depreciation, ranged from a low
of .1% of total assets in Michigan to a high of 1.6% in California.
Given this asset structure, lottery privatizations are unlikely to free up
significant amounts of government capital. If anything, the lack of
tangible lottery assets may act to depress sale prices by suppressing
a buyers ability to mark assets to market to reduce future tax
liabilities.5
Privatization has also been presented as a strategy for improving
the performance of government-operated enterprises. Two versions of
this argument have been made by lottery-privatization advocates. One

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

381

TABLE 1

FY 2006 Selected Balance Sheet Assets and Ratios

($ in Millions)
State
CA
$975.8

CO
IL
IN
MI
TX
$52.3 $100.0 $117.7 $155.0 $336.6

Total Short-term
Operating Assets
% of Total Assets
36.2% 88.9% 98.4% 60.2% 30.6% 23.4%
Restricted Short-Term $340.1 $35.2 $0.1
$7.0 $85.1 $173.7
Investments
Restricted Long-Term $1,657.8 NA
$1.0 $65.9 $350.8 $1,101.6
Investments
% of Total Assets
61.5%
NA
1.0% 33.7% 69.3% 76.6%
Total Restricted
$1,997.9 $35.2 $1.1 $72.9 $435.9 $1,275.3
Investments
% of Total Assets
74.2% 59.8% 1.1% 37.3% 86.1% 88.6%
Capital Assets - net
$42.9
$0.7
$0.7
$2.8
$0.4
$7.7
% of Total Assets
1.6%
1.2% 0.7% 1.4% 0.1%
0.5%
Total Assets
$2,694.1 $58.8 $101.7 $195.4 $506.1 $1,438.9
Source: Balance Sheets abstracted from Comprehensive Annual Financial
Reports for each states lottery.

is that private companies are more efficient than public agencies and
might be able to enhance revenues by reducing costs (Lucas &
Chorneau, 2007). Available data, however, suggest that potential
savings from cost reductions are likely to be small. Table 2 shows
pure operating expenses for the six lotteries of interest. These
expenses averaged just over 4.8% of total revenues with a low of
2.9% for Illinois and a high of 6.48% for Colorado. At those levels,
there is little room for improvement. Further, time-series analysis of
lottery expense data between 1991 and 2006 shows downward
trends in operating expenses as a percent of lottery sales in California
(-.41% of total revenues per year) and Colorado (-.25% per year).
Operating expenses were flat as a percent of annual revenues in
Illinois, Indiana and Michigan. Only Texas showed upward pressure on
operating costs with expenses increasing by .13% of revenues per
year.6 It is important to note that, in most states, operating expenses
include advertising costs which are necessary for both the
maintenance and growth of ticket sales.

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PURTELL & FOSSETT

As Table 2 shows, commission expenses present a slightly

different picture. They averaged 6.87% of revenues and nearly 58%
of combined commissions and operating expenses in the six target
states. Commissions increased as a percent of sales over the 1991to
2006 period in four of the six states. However, since commissions
are likely to be a necessary component of any operators expansion
strategy, curtailing commission growth may prove difficult and
unwise.
Second, some privatization advocates have argued that privatelottery operators could be freed from governmental control over
introducing new games and other innovations and could engage in far
more aggressive and effective marketing campaigns than public
lottery agencies, making it possible for them to compete more
effectively with other forms of gaming (Young, 2007). While not
impossible, it is highly unlikely that this situation would ever
materialize. Given the widely-held - and -accurate belief that lotteries
TABLE 27

Six Target States: Key Activity Statement Data

($ in Millions Ratios as % of Sales)
2006 Operating
Data
Ticket Sales
CAG*
Commissions
CAG*
Operating Expenses
CAG*
Prizes
CAG*
Proceeds - $
Proceeds - %
CAG (% of Sales)
CAG in $

State
CA
$3,585.0
5.46%
7.04%
0.53%
4.48%
-0.41%
53.9%
0.31%
$1,236.8
34.5%
0.00%
5.59%

CO

IL

IN

MI

TX

$468.8 $1,989.2 $816.4 $2,212.4 $3,774.7

4.4%
0%
3.5%
3.86%
-0.41%
7.4%
7.29% 6.94% 7.47%
5.08%
0.00% 0.04% 0.02% 0.05%
-0.01%
6.48% 2.94% 5.93% 4.17%
4.90%
-0.25% 0.00% 0.00% 0.00%
0.13%
59.7% 58.2% 60.4% 68.7%
61.2%
0.18% 0.54% 0.40% 0.43%
0.50%
$123.8 $670.4 $218.0 $688.1 $1,075.8
26.4% 33.7% 26.7% 31.1%
28.5%
0.00% -0.29% -0.37% -0.44%
-0.39%
2.20% 0.00% 2.20% 2.30%
0.00%

Note: * CAG is Compound Annual Growth shown as % of sales unless noted.

Source: Activity Statements abstracted from Comprehensive Annual
Financial Reports for each states lottery from 1992 to 2006.
Compound Annual Growth Rates derived from regressions of log
expenses against time.

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

383

are regressive fund-raising vehicles (Kearney, 2005), vocal moral

opposition to gambling in some quarters (Walker, 2008), and political
distrust of wealthy private companies, there is likely to be regulatory
resistance to aggressive marketing and unrestricted game innovation.
It is likely that increasing lottery participation, changing payout
structures or adding additional games will continue to require at least
the tacit support of legislators and, in some states, voters. Such
restrictions have already begun to appear. For example, Indianas
privatization proposal would not permit a private lottery-operator to
introduce new forms of gaming without the approval of the General
Assembly (Schnitzler, 2006), while Michigans Proposal 1 limits game
expansion without voter approval (Cain & Hornbeck, 2007).
Finally, Megginson and Netter (2001) note that governments
frequently see privatization as a tool for raising revenue without
raising taxes. The significant short-term revenues offered by lottery
sales and leases without the need to raise taxes are unquestionably
the primary reason for states considering these transactions,
particularly in times of budgetary difficulty when alternative revenue
sources are flat or declining. Under these conditions, there is a strong
temptation to see lottery sales as a windfall that obviates the need for
difficult and politically unpopular decisions to raise taxes or cut
services. This temptation should be resisted. Lotteries already
generate revenue streams that support on-going state programs.
Privatizing lotteries merely accelerates and discounts the collection of
those proceeds, producing additional current revenue by forfeiting
future lottery proceeds. Whether this transaction is financially
sensible is an empirical question we address in the next section of
this paper.
The budgetary consequences of this swap are not easy to
forecast. Lottery contributions to state budgets are modest at best,
amounting to no more than 8.5 percent of own-source general
revenue in any state in 2001 (Kearney, 2005). In 11 states, lottery
revenue is contributed to the states general fund rather than
earmarked for any particular use, but funds are more commonly
earmarked. Earmarked uses run a wide gamut from the general to
the particular, but K-12 education is the most common program for
which lottery funds are earmarked8 (Kearney, 2005). Evidence of the
effects of education earmarks on total education spending is
inconsistent. Earlier studies suggest that rather than increasing total
education spending, states tended to use lottery revenue to divert

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PURTELL & FOSSETT

state funds for other uses (c.f. Spindler, 1995; Miller & Pierce, 1997)
while more recent studies have found that lottery earmarks increase
total education spending significantly (c.f. Evans & Zhang, 2002;
Novarro, 2002).
These findings suggest that the division of lottery sale-proceeds
may be politically contentious. Conflict is particularly likely in states
with education earmarks, growing sales, and some evidence that
lottery revenue has expanded total education spending. In these
states, organized teachers and other education advocacy groups may
see themselves as being deprived of an important, and growing,
source of revenue and press demands that they be held harmless
against the loss of these funds into the future. Other actors, including
governors, may also be expected to lobby for alternative uses of these
funds. In California, Governor Schwarzenegger proposed diverting $8
billion in lottery privatization-proceeds to retire debt used to balance
the States budget. In similar fashion, Governor Perry of Texas
proposed dividing privatization proceeds among state education,
cancer research and expanded health-insurance coverage.
Under these conditions, political estimates of what it would cost
to replace previously earmarked lottery revenue are likely to vary
widely. Opponents of diverting funds may well argue, as proponents
of lottery privatization do today, that governments would not have
been able to maintain their historical growth rates and might even
have experienced declining proceeds over time. Rather, they might
argue, some significant portion of the observed post-privatization
growth was due to superior management skills brought to bear by the
for-profit operators. Even if politicians could agree on the size of the
growth-funding shortfall, they might still be reluctant to provide funds.
The money needed to plug any post-privatization gaps would have to
be drawn from the pool of limited discretionary funds that have
always been the main focus of budgetary debates.9 In such
situations, advocates for education and other earmarked causes
might be hard pressed to maintain what they perceive to be
equitable levels of funding.
Lottery privatizations also have the potential for generating
doubly-regressive outcomes. First, for-profit lottery operators focused
on maximizing cash flows will have an incentive to pressure
regulators to permit unbridled expansion of an ever-increasing variety
of games. To the extent they succeed and the demographic and

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

385

economic composition of lottery players does not change materially,

incremental lottery sales are likely to come disproportionately from
lower-income state residents. If lottery proceeds are used to support
programs which disproportionately benefit upper-income groups, the
overall incidence of the sale may become even more regressive.
Second, if states do not replace the funds lost to foregone lottery
growth, particularly if lottery funds had been earmarked for
education, the burden of maintaining funding at growth-adjusted preprivatization levels may fall to local property-owners. This could lead
to one of two outcomes. Either property taxes might have to be
increased across all school districts with the effect of burdening
poorer communities disproportionately or poorer communities may
decide not to increase funding adding to the disparities lotteries were
originally designed to mitigate.
Lottery privatization may also have unintended tax-distribution
consequences. Once sold to private operators, a portion of annual
lottery proceeds will be subject to taxation at both the federal and
state level.10 Two things happen as a result. First, the cash flows
which drive the lotterys value will be reduced based on the amount
and timing of these tax payments. Second, a portion of these tax
proceeds will be diverted to the federal government and, in instances
where states impose corporate income taxes, to the states general
operating funds. Once diverted, the federal portion of those funds is
unlikely to be redistributed to the states that generated them and the
taxes paid to the state will be subject to the normal political
processes that determine funding priorities and no longer dedicated
to their original purposes. The social-welfare implications of this
redirection of funds away from their earmarked purposes are difficult
to predict but they are likely to differ from those generated by preprivatization lottery-funding formulae.
Finally, the high proportion of restricted investment funds on the
lottery balance sheets (see Table 1) may add both to governments
post-privatization regulatory burden as well as to their level of
financial risk. These restricted assets are investments held to pay
deferred lottery prize claims. After privatization, lottery operators will
have the right to retain any excess of portfolio earning over lottery
claims. That may give lottery operators an incentive to make higherrisk investments in the hope of achieving higher earnings. If
increased portfolio risk leads to losses beyond the for-profit

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PURTELL & FOSSETT

operators ability to fund, state regulators are likely to face

substantial pressure to make good on any claims jeopardized by the
lottery operators investment strategy. That pressure would be further
increased by the likelihood that the lottery would return to state
control in the event of such a payment default. To the extent lottery
operators believe governments will indemnify them against
investment risk while they will reap the upside potential of aggressive
investment strategies, they may be inclined to increase portfolio
risk.11 This dilemma argues for retained control by the states over
funds intended for future prize payouts but retaining control might
have a negative impact on lease proceeds.
Selling or leasing state lotteries, in short, is a very different
political and financial proposition from most prior public-asset sales.
Rather than devices to free up funds that have been used to support
state-owned industries which produce goods or services, lottery sales
or leases are mechanisms for accelerating the collection of future
revenue from a funding stream that is already being used to support
on-going state activities. These transactions have been debated in
state political settings primarily as a means of realizing additional
budget revenue without much attention to the consequences of
disrupting established funding patterns. We turn now to an
assessment of these devices as a replacement for on-going lottery
revenue.
LOTTERY VALUATIONS AND POST-PRIVATIZATION CASH FLOWS

In the simplest terms, businesses, whether they are lotteries,

manufacturers or software developers, are worth the present values
of their future cash flows from operations and asset sales12
(Damodaran, 2006) adjusted for tax payments and discounted at the
buyers cost of capital.13 To value the six target lotteries, we applied
standard valuation models to a range of possible sale and lease
acquisition structures to estimate a range of values for the lotteries in
our six target states. For tax reasons,15 transactions structured as
leases rather than sales yielded the highest prices. The analyses that
follow are based on those values.
The lottery data used in these analyses were drawn from the
1991 to 2006 audited Comprehensive Annual Financial Reports
issued by the lotteries in the six target states16 California, Colorado,
Illinois, Indiana, Michigan and Texas. Table 2 above summarizes the

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

387

relevant cash flow and operating data and the trends in those data.
For valuation purposes, we exclude investment returns, which were
volatile for some states, from net income and based valuations solely
on operating profits.
For valuation purposes, we created an optimal buyer-profile using
the lowest tax rate (28.8%) and cost of capital (6.5%) for any of the
potential buyers identified in the press.17 As we mentioned earlier, we
did not adjust the buyers cost of capital upward to reflect the impact
of the higher degree of leverage a lottery acquisition is likely to
require. To the extent specific buyers have less favorable financial
profiles or capital costs rise as a result of prevailing market
conditions or the financing structure employed, the valuations
presented here may be overstated. We allowed that upward bias
intentionally. If these best-case scenarios and the sensitivity tests
that we used to analyze them do not generate a positive case for
lottery privatization, less favorable profiles clearly will not.
The lease-valuation procedure we used involved two steps. First,
we estimated the after-tax proceeds to the buyers over the lease
term. That required a three-step process. We estimated compound
growth rates for lottery profits for each of the states using OLS logregressions of lottery profits against time. Then, we applied those
growth rates to each states reported 2006 profit level to produce a
forecast of pretax proceeds over lease terms of 30 to 50 years. We
then adjusted those proceeds by subtracting the tax shield generated
by amortizing the full purchase price over the term of the lease using
the most aggressive amortization method18 allowed under tax
regulations to generate an estimate of taxable income for each year
of the lease. Finally, we netted the tax payments from the gross
profits to calculate the cash flow the buyer would capture in each
year. The second step in the valuation process involved calculating
the purchase price that was equal to the present value of the after-tax
cash flows captured by the buyer discounted at the buyers 6.5% cost
of capital. The advantage of this approach is that it is consistent with
valuation theory and can easily be replicated by other researchers
and the finance staffs of state legislative and executive bodies. The
results of that analysis are shown in Table 3.
The six target states we studied proposed a range of privatization
alternatives and transaction structures. California Governor
Schwartzenegger proposed leasing the states lottery which

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PURTELL & FOSSETT

generated over $1.2 billion in profits in 2006 for up to 40 years with

expected proceeds that ranged from a low of $12 to $24 billion
(Lucas & Chorneau, 2007) to a high of as much as $37 billion.
(Halpern, 2007) Colorado officials estimated its lottery with 2006
profits of roughly $124 billion would be worth $2.2 to 2.6 billion over
a lease term of up to 75 years (Couch, 2007; Legal Opinion Sinks
Sale, 2007). Indiana proposed leasing its lottery with 2006 profits of
$218 million for up to 75 years in return for a lump-sum of $1 billion
plus annual guaranteed payments of $200 million per year (Duhigg &
Anderson, 2007). Illinois, with 2006 profits of just over $670 million,
was open to either an outright sale or lease of its lottery with
expected proceeds of $10 billion (Shields, 2007). Michigan had
lottery profits of $688 million in 2006. No estimates were given for
the value of the lottery but a $10 billion number was used by officials
to illustrate how post-privatization proceeds might be distributed
(Cain & Hornbeck, 2007). Texas Governor Perry whose lottery had the
second highest 2006 profits of the states we analyzed with just under
$1.1 billion, announced that he wanted to lease the lottery for 40
years and expected to net at least $14 billion in proceeds (Selby,
2007). Texas Representative Bonner proposed an alternative
structure calling for $3 billion up front and annuity payments of $1.1
billion per year.
As Table 3 shows, Californias $37 billion target-price is
achievable at the states 5.6% historical rate of growth19 with a 45year lease while Michigans $10 billion value (Cain & Hornbeck,
2007) and Indianas20 $1 billion up-front price with royalty payments
of $200 million per year are achievable at lower rates of growth.
Assuming the three remaining states maintain their historical rates of
growth in net proceeds, Colorado, Illinois and Texas are unlikely to get
their asking prices unless buyers believe they can grow the lotteries
substantially faster than the states have been able to on their own.21
For example, to realize $2.6 billion in privatization proceeds,
Colorados lottery would have to raise its compound profit growth
from statistically zero to 3.95% per annum over a forty-year leaseterm. To get $10 billion for a forty-year lease, Illinois lottery proceeds
would have to increase profit growth to grow 1.75% per annum while
Texas would have to raise compounded growth to 3.2% per annum.
While the value estimates we have generated for the six states do
not necessarily represent absolute best-case pricing, they are

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

389

TABLE 3

State Lottery Valuations:22 30 to 50 Year Lease Terms

($ in Millions)
Valuation of Lotteries with Specified Lease Terms:
State
CA
CO
IL
IN
2.20% 0.00%
2.20%
Lottery Profits CAG* 5.59%
2006 Lottery Profits $1,236.8 $123.8 $670.4 $218.0

MI

TX

2.30%
0.00%
$688.1 $1,075.8

Lease term
30
35
40
45
50

$27,738
$31,283
$36,624
$37,784
$40,779

$1,777
$1,887
$1,973
$2,039
$2,091

$7,455
$7,709
$7,874
$7,978
$8,039

$3,130
$3,324
$3,475
$3,592
$3,682

$10,003
$10,637
$11,133
$11,521
$11,824

$11,963
$12,371
$12,637
$12,803
$12,901

Note: * CAG is Compound Annual Growth

Source: Computations by the authors using the methodology outlined above.

optimistic for several reasons. First, we have assumed that the

buyers cost of capital will not rise to reflect the increase in leverage
such a transaction would impose on the buyers balance sheet.
Further, the historical cost-of-capital estimate we used may not fully
reflect the current cost of funds given the turmoil in the leveragedfinance markets. As a buyers cost of capital rises, lease proceeds will
decline. Second, as Table 2 shows, four of the six states are
experiencing upward pressure on commission expenses as a percent
of total ticket sales while the ratio of prizes to ticket sales has been
increasing for all six states. If these expense increases are only
partially offset by reductions in operating expenses, it is likely to
depress profit growth over the long term and with it lottery values.
To the extent that the cost of capital is higher than we have
estimated, potential buyers feel their flexibility in game innovation is
likely to be restricted by regulators or their ability to drive down
expenses is limited by market forces, privatization pricing may be
lower than either we or the investment banking community has
estimated.
The valuations presented here are also optimistic in that they
ignore several practical problems with lottery privatization. First, we
have ignored the issue of whether there are a sufficient number of

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qualified bidders to guarantee fair-market pricing. This is not an

inconsequential consideration. Connecticut withdrew its lottery
privatization proposal in the 1990s due to a lack of what it deemed to
be qualified bidders. Second, the sheer size of these transactions and
the recent uncertainty in leveraged-finance markets puts into
question whether these deals can be financed at any price today. A
consortium led by CitiBank recently withdrew its bid to lease the
Pennsylvania Turnpike arguably driven by financing considerations.
Third, these deals are large compared to the market capitalizations23
of the buyers that have been identified in the press. Even if we
assume buyers will be able to leverage 90% of the purchase price of
a lottery, a single buyer would have to invest some $3.7 billion in
equity to purchase the California lottery alone. That number exceeds
the total market capitalization of the majority of potential buyers
identified in the press.24
The final question in the privatization analysis is whether the
states would be better off fiscally by privatizing their lotteries and
investing the proceeds or continuing to operate them. Our findings
suggest that states face a classic catch-22. To justify high prices,
lotteries must demonstrate strong historical growth and future
growth-potential. Yet, as we show below, that same growth virtually
insures that, during the lease term, fixed annual post-privatization
revenues will fall below what a growing lottery would have generated.
To analyze the post-privatization implications of leasing the
lotteries, we assumed that one-hundred percent of all lotteryprivatization proceeds from 40-year leases25 would be invested in a
fixed-income portfolio structured to produce predictable, stable
annual returns. To the extent that states choose to divert some or all
of the lottery-privatization proceeds to other purposes and not invest
those funds, returns will be lower than we report. We also considered
including equity investments in our analysis but rejected that option
because the volatility associated with equity investments is not
consistent with the goal of generating predictable annual revenues to
fund targeted operations. We also analyzed but did not include
annuities among the investment alternatives reported below. There
were three reasons for that. First, it is not clear that the annuity
market is large enough to absorb the stream of funds that a broad
lottery-privatization movement might generate. Second, unlike the
fixed-income markets it would be difficult to structure a broadly

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391

diversified portfolio of annuity assets. Without sufficient

diversification, the states would be subjected to credit risks
concentrated in a limited number of annuity providers. Finally, the
differential cash-flows between annuities and fixed-income
investments were not large enough to have a material impact on the
findings.
We considered investments in portfolios of US Government Bonds
yielding 5.26%, a portfolio of investment-grade corporate-bonds
yielding 6.19%, a portfolio of thirty-year Fannie Mae guaranteed
mortgage-backed securities yielding 6.5%, and a portfolio of high-yield
corporate bonds yielding 8.1%.26 Since it is not possible to forecast
future interest rates, we chose a passive buy and hold strategy for all
of our comparison portfolios. In addition, we ignored the fact that the
term of the lottery lease, 40 years, was different from the maturities
in the model portfolios which ranged from 25 to 30 years and
assumed the states would be able to rollover their investments at the
same rate as the underlying portfolio.
Table 4 illustrates the results of that analysis for the Colorado
Lottery for each of the four investment alternatives included in our
analysis along with the 9% expected rate of return announced by the
governors of Michigan and Texas. The numbers in the table represent
TABLE 4

Differences between Investment Returns and Projected Lottery

Profits: State of Colorado Lottery Privatization
($ in Millions)
Year

US
Governments

Rate
1
5
10
12
15
17
20

5.26%
($22.7)
($34.2)
($50.1)
($56.9)
($67.8)
($75.4)
($87.5)

InvestmentGrade
Corporate
Bonds
6.19%
($4.37)
($15.9)
($31.7)
($38.6)
($49.4)
($57.1)
($69.1)

FNMA
MortgageBacked
Securities
6.50%
$1.8
($9.8)
($25.6)
($32.5)
($43.3)
($50.9)
($63.0)

High-Yield
Bonds

Assumed
Returns in
MI & TX

8.10%
$33.3
$21.8
$6.0
($0.9)
($11.7)
($19.4)
($31.5)

9.00%
$51.1
$39.6
$23.7
$16.9
$6.0
($1.6)
($13.7)

Source: Computations by the authors using the methodology outlined above.

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PURTELL & FOSSETT

the differences between the return Colorado would earn by investing

the full proceeds of a 40-year lease of its lottery at the returns offered
by each of the securities and what the state would have earned from
its lottery assuming it continued to grow at 2.2% per annum.28 Were
the state to invest the privatization proceeds in US Government
Bonds, our analysis shows an immediate funding shortfall of $22.7
million rising to nearly $87.5 million within 20 years. As investment
returns rise, privatization offers Colorado short to medium-term
benefits. For example, by investing in high-yield bonds, the state
would enjoy improved annual cash flows through the twelfth year
following privatization. Not surprisingly, the fiscal efficacy of the
privatization strategy rises with the assumed rate of return and, as
Table 5 shows, with the historical rate of growth in lottery profits.
When considering these results, it is important to remember that
as investment returns rise, risk rises. If a driving force beyond
privatizing lotteries is reducing government risk, investing in high-yield
bonds or even riskier securities would not, in our opinion, meet that
goal. Rather, privatization may simply substitute investment risk for
operating risk.
Table 5 shows the crossover years for each of the four lotteries California, Colorado, Indiana, and Michigan - that experienced
statistically significant growth over the 1991 to 2006 period. We find
that lottery-privatization does make short- to medium-term fiscalTABLE 5

Year When Projected Lottery Proceeds Exceed Investment Yields

US Government Bonds
Investment-Grade Corporate Bonds
FNMA Mortgage-Backed Securities
High-Yield Bonds
Assumed Returns in MI & TX

Rate

CA

CO

5.26%
6.19%
6.50%
8.10%
9.00%

8
11
12
18
18

*
*
2
12
17

IN
Annuity
7
8
9
12
13

MI
*
*
*
12
16

Note: * Lottery proceeds always exceed investment returns over the 40-year
lease term.
Source: Bloomberg Data Systems and computations by the authors using the
methodology outlined above. Since the time these computations were
done, fixed-income market rates of return have declines substantially.

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

393

sense in those growth states for some classes of investments and

that the longevity of those fiscal benefits is a function of historical
lottery growth.
In contrast, privatization only makes sense for Illinois and Texas,
where historical growth rates were statistically zero, if they can earn
in excess of 8.5% per annum.29 At rates lower than that, lottery
proceeds always exceed post-privatization investment returns. Table
6 shows the differences between projected lottery profits and returns
on the investment of the proceeds of a 40-year lottery lease for
Illinois and Texas for each of five investment options. Unless Illinois
and Texas can earn returns above that 8.5%, lottery privatization
does not make fiscal sense. Above that rate, they not only make
short- to medium-term fiscal sense but benefits persist throughout
the entire term of the lease. This counterintuitive finding that zerogrowth produces the only sustainable stream of privatization benefits
is a result of the negative impact of taxes on post-privatization cash
flows and the interactions between discount and growth rates.
TABLE 6

Differences between Investment Returns and Projected Lottery

Profits: States of Illinois and Texas
US Government Bonds
Investment-Grade Corporate Bonds
FNMA Mortgage-Backed Securities
High-Yield Bonds
Assumed Returns in MI & TX

Rate
5.26%
6.19%
6.50%
8.10%
9.00%

IL
($256.2)
($182.9)
($158.5)
($32.5)
$38.3

TX
($411.1)
($293.6)
($254.4)
($52.2)
$61.5

Source: Computations by the authors using the methodology outlined above.

In all valuation analyses, tax payments diminish pricing by

reducing the cash flows that a for-profit buyer can capture. Consider
that at the 28.8% tax rate we used in this model, for-profit lottery
operators will realize only 71.2 cents of after-tax profits for each
dollar of taxable income. While, the tax effect impacts all lottery
privatizations, its impact is felt most heavily where there is no growth
to offset it. While tax payments act to reduce value, growth increases
value. Without growth, there is no mechanism for reducing the
downward pressure that taxes place on value.
In addition, valuations of zero-growth lotteries bear the full weight
of discounting while, in a sense, growing lotteries do not. In effect,

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PURTELL & FOSSETT

growth reduces valuation discount rates and increases value. For

example, in Colorado where lottery proceeds grew by 2.2%, the
effective discount rate is not 6.5% but approximately 4.3%.30 Growth
effectively pays for part of the discount. As a result, lottery value
rises with growth.
All other things being equal, lottery leases can only produce postprivatization benefits when the rate the states earn on postprivatization investments exceeds the effective valuation-discount
rate, adjusted for the tax effect. In states with positive profit growth,
those benefits existed for some combinations of growth and
reinvestment rates but they were eliminated within 2 to 18 years. For
zero-profit-growth states the 6.5% discount rate was greater than the
returns available from either government securities or investmentgrade corporate bonds and equal to yield on mortgage backed
securities at the time we did this analysis. Even in the absence of
taxes, investing in those securities could never work for zero-growth
states. Because of the downward pricing pressure imposed by the tax
effect, even investing in high-yield corporate bonds31 failed to
produce even short-term benefits. The only way to overcome the
impact of discounting and taxes with zero-growth is for states to seek
investment returns that not only exceed the effective discount rate
but also add enough additional yield to offset tax impacts. At 8.5% in
zero-growth states, that happens. However, as we mentioned earlier,
as expected returns rise, risk rises. Privatizing lotteries and investing
the proceeds in high-yield securities just exchanges one type of risk
for another.
Although, privatization-values announced by three of the states
we analyzed were consistent with our models, post-privatization
proceeds were insufficient to replace lottery proceeds over the term
of the lease after factoring in the growth rates used to arrive at
privatization prices. That suggests that privatizing state lotteries
makes, at best, short- to medium-term sense except in the extreme
case of zero lottery-growth combined with a high-risk investment
strategy.
However, our analysis also suggests that value is, perhaps not
surprisingly, dependent on deal structure. For example for tax
reasons, leases produced higher prices than outright sales. Also
unsurprisingly, values were inversely related to the discount rates
used. We also found that transactions structured with guaranteed

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

395

annual payments combined with reasonable up front payments

yielded more sustainable results than full operating leases even with
relatively-low growth rates. That finding results from the fact that the
guaranteed royalty payments were set at or even slightly above
annual lottery earnings in 2006, the last year for which we had data.
As a result, earnings from the up-front payments combined with the
annuity put the states ahead of where they would have been without
the lease. In essence, these transactions set 2006 profits as a floor
for future cash flows, discounted growth and invested that growthpremium to generate incremental returns that persisted over the
medium term. As a result, both the Indiana proposal of a $1 billion
up front payment with guaranteed continuing $200 million payments
and the proposal by Texas Representative Bonner of $3 billion up
front and $1.1 billion per year produced longer sustained benefits
that did the outright sale proposals in those states. However, it is
important to note that neither of these structures produced
incremental returns that persisted throughout the full forty-year lease
term. However, mixed-payment transactions add an additional
tradeoff to the privatization decision. They require less up-front cash
which should make them easier and, possibly, less expensive to
finance. But they expose governments to the risk that the lottery
lessees may be unable to meet their annual payment obligations.
All of that suggests that governments considering privatization
might want to explore alternative vehicles for achieving their goals.
Our analysis suggests that structures with some or all of the following
characteristics -- minimizing post-transaction tax payments,
combining up-front cash payments with annuities, preserving some or
all of the growth for the states, and minimizing discount rates might
prove advantageous.
ALTERNATIVES TO PRIVATIZATION

The outlook for state lottery sales or leases was complicated in

October, 2008, when the Office of Legal Counsel (OLC) of the
Department of Justice issued a memorandum opinion which held that
exemptions granted in federal law to lotteries conducted by a state
do not apply to lotteries operated by private companies under
contract with the state (OLC, 2008). This opinion appears to have led
some states, at least temporarily, to halt consideration of lottery
privatization measures (Devitt, 2008).

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It is far from clear, however, that this opinion eliminates the

possibility of lottery sales or leases without a change in the federal
lottery statutes. OLC typically issues opinions to other federal
agenciesthe lottery opinion came in response to a request from the
Criminal Division of the Department of Justiceon matters of
interpretation of the laws under which they manage their operations.
These opinions are as labeledopinions, which are not legally binding
in the same sense as case law, statutes or other administrative
actions such as executive orders or agency rules published in the
Federal Register. States can challenge the OLC opinion or defend
their particular structure in federal court and a federal judge could
rule in favor of the states particular arrangements or against OLCs
overall interpretation of the federal lottery statutes.32
States could also attempt to game the opinion by devising
management and financing structures which provide the same
advantages as a lease or sale, but which could be defended as falling
within the standards for a lottery conducted by a state. Since state
lotteries already rely heavily on private contractors for a wide range of
services under a variety of incentive contracts and financing
arrangements and at least some of which are explicitly sanctioned by
the opinion, that would seem to provide some measure of flexibility in
how states might work within the opinion to meet their goals.
Specifically, the OLC opinion requires that the states control the
lottery and have custody over the proceeds and prize payouts from
the lottery while allowing them to enter into performance-oriented
contracts with management companies. It is not hard to conceive of
structures that combine the required elements of control with
creative incentive contracts. One such possibility might include an
incentive game-development agreement that gives the private
manager some share of increased proceeds with a structured
financing that combines both fixed and proceeds-based interest
payments in return for providing the state with an immediate influx of
cash. Combinations like that could provide states with the cash they
desire without violating the spirit of the OLC opinion.
Properly structured, such arrangements are natural extensions
of the virtual management models most of the states have been
using for years. In addition, since long-term historical growth rates
can be estimated statistically, it should be possible to specify
monitorable contracts that would provide reasonable assurance that

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

397

profit-sharing payments reasonably reflect performance. However,

such near-lease structures are likely to generate fewer dollars of
proceeds and be less attractive to the states.
Another alternative for accelerating the collection of lottery profits
might be a complete or partial securitization of future lottery
proceeds.33 Hypothecating lottery proceeds would allow the states to
generate some amount of immediate cash while preserving
ownership and control of the lottery. While a complete analysis of the
full range of securitization options is complex and beyond the scope
of this paper, the securitization option may offer three important
advantages. First, with proper structuring, the debt could be issued
on a tax-exempt basis,34 with the effect of lowering discount rates,
enhanced to produce a high credit-rating, and kept off the states
balance sheet. Second, since lottery profits would remain under the
control of state government, they would be exempt from taxation.
Finally, securitization could be used to preserve the states right to
retain cash-flows in excess of what will be required for debt service
and credit enhancements. Taken together, these factors could be
used to either increase the absolute amount the state could raise
from its lottery or reduce the cash-flow required to produce some
targeted level of current funds. With proper design, securitization
might serve to generate the desired amount of immediate revenue
while extending the benefits from accelerating the collection of future
lottery proceeds or possibly make such benefits cover the full life of
the securitization.
Partnering and securitization alone or in combination might prove
to be more attractive long-term alternatives for the states than the
types of privatization transactions that have been proposed to date.
CONCLUSIONS

These findings suggest that, at least in the short run, lottery sales
or leases may be difficult for states to implement. The analysis
reported here clearly suggests that, even in normal market
conditions, lottery privatization makes at best short to medium term
financial sense for states. In addition, the recent OLC ruling, the
potential political controversy of lottery privatization, and the difficulty
potential purchasers are likely to experience raising the necessary
capital may make large-scale privatization unattractive in the current

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PURTELL & FOSSETT

environment. Large scale deals to privatize roads and bridges have

been recently downsized or put on hold for similar reasons.
At the same time, securitization or other alternative financial or
contracting structures of the type discussed above may offer states
the opportunity to tap future lottery proceeds in a reasonable manner
that avoids the political, financial and legal issues associated with
sales or leases. Lottery proceeds have historically held up well in
recessions, which may allow states to offer competitive returns to
investors in spite of other state financial problems. Clearly, states and
their financial advisors have an incentive to attempt to tap lottery
value in difficult financial times. Estimates of the value of state
lotteries range as high as $250 billion, with fees to bankers who
arrange the transactions in the $2.5-3 billion range. Under these
conditions, states might be expected to seek alternative means to tap
lottery profits. California, for example, included a proposal to allow
the state to borrow lottery profits (Legislative Analysts Office, 2009) in
a package of budget reform measures recently rejected by the states
voters, and similar proposals might be expected to surface as states
struggle with continuing budget difficulties.
NOTES

1. In this context, reasonable valuation ranges are based on the

buyers perspectives using their costs of capital as discount rates
and applying them to historical rates of growth in cash flows.
2. The taxonomy suggested by Megginson and Netter draws heavily
on two publications produced by Price Waterhouse in 1989
describing the British privatization experience.
3. Source: Texas Lottery Audited Comprehensive Annual Financial
Reports (2008).
3. Worldwide there are five major suppliers of lottery services
Camelot Group LLC (the sole operator of Great Britains Lottery),
Intralot S.A. (the sole operator of the Greek National Lottery),
Lottomatica (the operator of the Italian Lottery and owner of
GTech, a US service provider), International Game Technology,
and Scientific Games Corp. Gtech, IGT and Scientific Games are
active in the US lottery-service market.

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399

4. Balance sheets were drawn from the Comprehensive Annual

Financial Reports for each states lottery. Illinois shows a far
lower proportion of funds invested to pay future prizes. However,
the proportion of fixed assets to total assets is consistent with the
other target lotteries. Investment assets for Michigan have been
adjusted downward to reflect excess collateral amounts
deposited with the state for securities loan programs. That
adjustment makes Michigans investment balances comparable
to the other target states. Colorado categorizes all investments as
short term.
5. As we discuss later, post-privatization profits are taxable to buyers
to the extent they exceed depreciation and amortization
allowances.
6. Operating trend estimates were derived through log regressions
of each expense as a percent of total lottery revenue against
time. Where operating-expense trends for either commissions or
operating expenses were significant, they were below the .001
level.
7. State-lottery compound growth-rates were estimated through OLS
log regressions of each measure against time for the period 1991
to 2006. Because of the impact of partial-year data on parameter
estimates, Texas regressions were run using 1993-2006 data.
The non-zero growth estimates reported above were significant
with p < .001 level, regression R2s ranged from .81 to .93 and all
F-statistics were significant at the .001 level or better.
8. Kearney notes that earmarks range from such broad designations
as economic development and tax relief to the very specific
her examples are Mariners Stadium in Washington and police and
fire pensions in Indiana.
9. Given the current recession brought on by the collapse of the subprime mortgage market and the contagion that has spread into
the tax-exempt finance markets, discretionary funds are likely to
be scarce and hotly contested for the foreseeable future.
11. The amount of proceeds subject to taxation will depend on the
amortization tax shield engineered into the purchase structure
and the method each buyer chooses to amortize that tax shield.

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12. The importance of this point has been driven home by the most
recent relative performance statistics for lotteries and financialmarket instruments. For example, New York State reported that
fiscal year 2008 lottery proceeds were up 3% while potentially
high-yield investments like stocks and hedge funds were reporting
losses in excess of 35% and many high-yield fixed-income
securities could not be priced with any degree of certainty.
13. In cases where businesses have redundant, undervalued or
underutilized assets, cash flow may come not only from operating
profits but also from the sale of those assets and/or the taxshield they generate when marked to market. Based on the
proportion of real assets on lottery balance sheets (see Table 1),
asset sales are unlikely to be a significant source of value in
lottery privatizations. For a discussion of valuation models, see
Damodaran (2006).
14. The cost of capital is the weighted average of the rate of return
that investors demand to hold a companys stock, the cost of
equity, plus the companys marginal cost of debt. For example, if
a company were to use 30% equity and 70% debt with a cost of
equity of 8% and a marginal borrowing cost of 6%, its cost of
capital would be 30% * 8% + 70% * 6% = 6.6%. Although there is
still some debate about the use of discounting methods for
capital budgeting especially among smaller nonprofits and
governments, present value models are almost universally used
in corporate valuation analyses (c.f. Damodaran, 2006). Since the
valuations derived here are being done from the perspective of
large for-profit buyers, we feel confidant applying net present
value methodology.
15. In a lease, the full acquisition price can be amortized over the
lease term creating a tax shield that reduces the portion of net
lottery proceeds subject to state and local taxes, raises net cash
flows to the buyer and increases the value of the lottery. In
contrast, the lack of tangible assets in lotteries severely restricts
the size of the purchase tax-shield reducing net after-tax cash
flows and, with that, the value of the lottery.
16. The only exception to the time period analyzed was for Texas
which started lottery operations in 1992.

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

401

17. We generated a best case combination of capital costs and tax

rates to value the lottery privatizations. The tax-rate and cost-ofcapital estimates are for Lottomatica SPA, the operator of the
Italian National Lottery. They represent the lowest combination of
those two factors for any of the potential buyers mentioned in the
press. The cost-of-capital estimate was provided by Kepler
European Research. In the constrained debt markets faced by
potential buyers after the collapse of the sub-prime mortgage
markets, the cost of equity, leverage ratios and debt costs we
applied may prove optimistic. However, the impact of raising
either cost of capital or debt rates or reducing leverage would be
to reduce the prices buyers might be willing to pay.
18. A tax shield is defined as the amount that can be deducted from
taxable income before calculating the portion of income subject
to taxation at either the federal or state level. The most
aggressive method proved to be sum-of-the-years-digits. Sum-ofthe-years- digits is an aggressive, accelerated method of
depreciation that maximizes tax deductions in the earliest years
of the lease.
19. It is unlikely that any state will be able to maintain high levels of
lottery growth over the life of the lease. In its analysis of the
potential sale price for the Vermont Lottery, Lehman Brothers
bankers reduced projected growth estimates from 3.5% to .5%
after five years.
20. The Indiana valuations and related growth rates assume the
buyer does not pay the state 5% of revenues above $700 million
included in the governors proposal. With that premium, the
transaction is not feasible.
21. Because of the extreme discounted values of cash flows beyond
50 years, lottery valuations do not change appreciable for 75versus 50-year leases. As a result, we have not presented
valuations for 75-year lease terms.
22. Michigan Government officials announced neither an expected
price nor the proposed terms of sale. The $10 billion number was
offered by Tom Clay of the Michigan Citizens Research Council
(Cain & Hornbeck, 2007).

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PURTELL & FOSSETT

23. Market capitalization is the product of a public companys share

price multiplied by the number of shares of stock outstanding in
the market.
24. Financial buyers might replace industry participants but such
buyers are likely to demand significantly higher returns on equity
than have historically been achieved by participants in the lotteryservice industry.
25. Lengthening or shortening the lease term did not have a material
impact on the results presented here.
26. Rates used for this analysis are from October 19, 2007. Since
changes in interest rates will be reflected both in the cost of
capital used to calculate privatization proceeds and the returns
available in the market, interest rate movements since that time
will have little impact on our findings. Given the current turmoil in
the leveraged finance markets, updating the rates used in the
analysis would have had the impact of increasing each acquirers
cost of capital, lowering returns on the safest investment
alternatives, and accelerating the points at which lottery proceeds
would have exceeded fixed-income returns.
27. This assumption is not critical to our findings. In all cases, returns
from the investment of privatization proceeds fell below projected
lottery proceeds long before the portfolios reached maturity.
28. To calculate the estimated lottery proceeds in each year, add the
annual differences between the fixed-income portfolio and lottery
proceeds to the product of the fixed-income return times
expected lease proceeds. For clarity sake, we chose not to show
all of the numbers used in the calculations.
29. For comparative purposes, most state pension plans assume
compound annual returns of 8% per annum.
30. This impact is illustrated by what is called the constant-growth
dividend model (c.f. Damodaran, 2006, pp. 158-9) where stock
value is estimated as current dividend divided by the riskadjusted rate of return for a security minus the expected rate of
growth in dividends over time.

HEY YOU NEVER KNOW: SELLING STATE LOTTERIES IN AMERICA

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31. High-yield bonds are often referred to as junk bonds and are
one of the classes of fixed-income investments that have been
most heavily impacted by the sub-prime debt crisis.
32. In American Civil Liberties Union, et al., v. Department of Justice,
(Civil Action Nos. 06-00096 (HHK), 06-00214(HHK)), the opinion
states in reference to an OLC opinion "Memoranda issued by the
OLC, including this one, are binding on the Department of Justice
and other Executive Branch agencies and represent the official
position of those arms of government." Missing is the direct
statement that OLC opinions carry the same force outside the
federal executive branch. The Courts decision in United States
Court of Federal Claims, TENASKA WASHINGTON PARTNERS II,
L.P., Plaintiff,v. The UNITED STATES, Defendant. no. 95-420C
(Nov. 9, 1995) is more explicit; Because the OLC Memorandum
is binding on the Department of Justice and other Executive
Branch agencies, (a federal agency) is bound to assert the
position. Of course, the fact that the Department of Justice
asserts a legal theory does not bind the court to accept the
reasoning as legally correct;
33. Securitizations involve pledging future lottery receipts and
borrowing against them. Partial-securitization structures would
only borrow a portion of future projected lottery profits and could
be used to mirror the privatization proposals put forth in Indiana
and Texas without resorting to an outright sale or lease.
34. The states would have to be careful to structure their
securitizations and resultant investment vehicles to comply with
the restriction imposed by what are referred to as IRS Section148 arbitrage regulations that effectively prohibit borrowing on a
tax-exempt basis for the purpose of investing in higher-yielding
taxable instruments.
REFERENCES

Cain, C. & Hornbeck, M. (2007, January 26). State Bets Lottery Sale
Could Fix Deficit. DetroitNews.com. [On-Line]. Available at
www.DetroitNews.com.
Couch, M. P. (2007, April 22). Vets Pushing for Vote on State-Lottery
Sale. The Denver Post: C-04.

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Damodaran, A. (2006). Damodaran on Valuation (2nd ed.). Hoboken,

NJ: John Wiley and Sons.
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APPENDIX I

Key Operating Statistics for Lotteries in the US

Sate

AR
CA
CO
CT

2006
Gross
Revenue
($ in
Millions)
$469
$3,585
$469
$970

Prize
2006 Net
Operating
Gross
Net
Revenue Revenue Per Expenses & Payouts as Revenue
($ in
Commissions % of Gross as % of
Capita
Millions)
as % of Gross Revenues
Gross
Revenues
Revenues
$141
$76
15%
55%
30%
$1,259
$98
11%
54%
35%
$126
$99
13%
60%
27%
$285
$277
10%
61%
29%

406

PURTELL & FOSSETT

APPENDIX I (Continued)
Sate

DC
DE
FL
GA
ID
IL
IN
IO
KA
KY
LA
MA
MD
ME
MI
MN
MO
MT
NC
ND
NE
NH
NJ
NM
NY
OH
OK
OR
PA
RI
SC
SD
TN
TX
VT
WA
WI
WV

2006
Gross
Revenue
($ in
Millions)
$266
$728
$3,929
$2,995
$131
$1,964
$816
$340
$236
$742
$332
$4,501
$1,561
$230
$2,212
$450
$914
$40
$866
$22.3
$113
$263
$2,407
$155
$6,803
$2,221
$205
$1,101
$3,070
$1,731
$1,145
$688
$928
$3,775
$105
$478
$509
$1,523

Prize
2006 Net
Operating
Gross
Net
Revenue Revenue Per Expenses & Payouts as Revenue
($ in
Commissions % of Gross as % of
Capita
Millions)
as % of Gross Revenues
Gross
Revenues
Revenues
$74
$458
17%
55%
28%
$316
$146
NA
NA
43%
$1,225
$217
9%
60%
31%
$822
$316
11%
61%
28%
$33
$90
17%
58%
23%
$646
$153
8%
59%
33%
$216
$129
13%
60%
27%
$81
$114
40%
36%
24%
$67
$85
17%
55%
28%
$204
$176
12%
60%
28%
$119
$77
13%
51%
36%
$951
$699
7%
72%
21%
$501
$278
10%
58%
32%
$52
$174
16%
62%
22%
$688
$219
12%
57%
31%
$119
$87
13%
60%
27%
$261
$156
8%
63%
29%
$9
$42
25%
52%
23%
$314
$100
13%
52%
35%
$6.5
$35
22%
49%
29%
$28
$64
20%
56%
24%
$80
$200
11%
58%
31%
$844
$276
8%
57%
35%
$37
$79
21%
55%
24%
$2,203
$336
11%
57%
32%
$646
$193
12%
59%
29%
$69
$57
12%
54%
34%
$571
$98
NA
NA
51.9%
$992
$247
9%
59%
32%
$324
$244
11%
70%
19%
$321
$265
11%
61%
28%
$119
$50
NA
NA
17.3%
$285
$154
11%
58%
31%
$1,090
$161
10%
61%
29%
$23
$168
15%
63%
22%
$125
$75
13%
61%
26%
$133
$92
16%
58%
26%
$610
$120
NA
NA
40%

Source: Lotteries Profit But Do Students, New York Times, Online Feature,
October 5, 2007.