The Case for Private Prisons

Over the next decade, the private sector’s share of inmates within the U.S. could increase to 11 percent from its current level of 8 percent. This equates to roughly 5 percent to 7 percent annual inmate growth over that time.
There are a confluence of events driving what should be a multi-year acceleration of private sector inmate growth:
• The current supply-demand imbalance within the industry
• High recidivism rates
• Cuts to core programs aimed at lowering recidivism
• State budget woes
• California’s dire need for beds
• Potential new entrants into the private sector
Supply-Demand Imbalance
Over the next two years, based on an analysis of states that currently use some form of private corrections, there should be more than 70,000 net new federal and state inmates.
However, during the same period, there are only an estimated 30,000 new beds coming into the system, predominantly from the private sector. Therefore, there are expected to be 2.5 net new inmates coming into the system for every new prison bed. This imbalance is unlikely to change for several years given the consistent inmate growth and the lack of funds within the government to build new beds.
High Recidivism Rates
One of the primary drivers for inmate growth in the U.S. prison system over the past decade has been the high rate of recidivism.
Recidivism rates within various prison systems run between 30 percent and 50 percent. This rate could trend up over the next several years due to significant budget-related program cuts for education, vocational training, drug and alcohol rehabilitation, parole services and halfway houses, as well as high unemployment rates.
Add to this tough sentencing laws that attach longer sentences to subsequent criminal offenses, and the overall inmate population in the United States is poised for accelerating in growth over the next several years.
State Budget Pressures
States are expecting another challenging year for department budgets given the continued deterioration in tax revenues caused by high unemployment, declining real estate values and low levels of consumer spending.
For departments of corrections, there are a limited number of levers that can be pulled to trim costs before public safety is compromised. Considering that fiscal year 2011 budgets will represent a second year of funding challenges, state options of cutting spending on programs — rehabilitation, education, vocational training and re-entry services — or overcrowding their own facilities have been essentially exhausted. Aside from sentence reform, which is unlikely, the increased use of private prisons represents the only viable solution.
New Entrants

Another driver of inmate growth in the private sector will be new entrants. California is currently operating close to 170 percent of its maximum capacity and is under federal court orders to reduce its population by 40,000 inmates.
Given its budget problems and the high cost of building and running its own prisons, one of the solutions California has turned to is the private sector. Over the long term, California could represent an annual demand of 15,000 to 20,000 beds versus its current demand of roughly 10,000 beds. California’s private sector bed usage was zero in late 2006.
Pennsylvania’s overcrowding and budget problems have forced the state to look to ship inmates out of state for the first time in its history. Pennsylvania is currently looking for space for roughly 2,000 inmates. Over time, the economic pressures could push other states to use some form of private corrections for the first time.
Private Sector

Over the next year, state DOCs may be able to mask their budget declines with further cuts to programs, along with more overcrowding in their facilities. However, this is only a temporary solution, and one that is finite.
The corrections system within the United States has reached a breaking point, one where simple mathematics indicates the need for a dramatic change. Small, finite solutions, such as program cuts and overcrowding, do not solve the problem of steady inmate population growth with no capacity growth. There are only two solutions that can address the supply-demand imbalance within the system: sentence reform or increased use of the private sector.
Without going down a sociological path and tackling the issue of whether the current system is working or not, sentence reform will not be a feasible option because the legislative process takes too long, holds too high of a risk — without corresponding rehabilitation services, lighter sentences will not eliminate re-offense — and is political suicide.
Many recall the Willie Horton campaign that torpedoed the Michael Dukakis presidential bid in 1988. More recently, and certainly as high profile, is Maurice Clemmons, the former felon released early from prison in Arkansas who allegedly murdered four police officers in Washington. It only takes one high-profile case to take sentence reform off the table.
Without sentence reform or a miracle funding solution, the only feasible option over the coming years to address inmate growth in the United States is the increased use of the private sector. The competitive advantages of the private sector include cost and access to capital, which we believe will remain in place for years to come. 
The private sector can operate facilities 10 percent to 15 percent more cost effectively than the government due to a combination of corporate benefits packages (versus government benefits) and design efficiency — better-designed facilities that allow for more optimal staffing levels.
The private sector also enjoys a cost advantage with respect to constructing new facilities. Private operators can construct a new expansion bed in one year for $35,000 to $45,000 per bed and a new greenfield bed in two years for $60,000 to $70,000 per bed. For comparable beds at a state or federal facility, it would take three to four years and cost 50 percent to 100 percent more. Private operators also have greater access to capital to build new beds through the combination of internally generated cash flows and access to the capital markets. The government must rely on budget appropriations for new bed construction.
Government involvement can certainly cloud any economic clarity. However, the system has reached a critical level, and increased use of the private sector is not only the most economical solution, it is also the solution that carries the least amount of political risk.
Therefore, the acceleration of inmate growth within the private sector is a multi-year trend that could begin as early as the second half of 2010. From an investor’s standpoint, this situation feels a bit like having the answers to a test before school has even started. 
T.C. Robillard, Jr. is director and senior research analyst for the business services sector at Signal Hill Capital Group. Robillard previously served as head of the business services research team at Bank of America Securities, with responsibility for all sub-sectors, including corrections.