State and local governments are among the country’s largest customers, but one of its least appreciated investment themes. Here, Managing Director Matthew Wiederrecht, head of Capstone’s State & Local Governments practice, highlights the many underappreciated investment opportunities in the sector. We sat down with Matt to discuss the voracious appetite that local governments have for the private sector to do a wide variety of jobs, from road-striping to tech modernization to back-office compliance paperwork, the risks that come with investment, and how investors can get involved.
Q: Where are the investment opportunities in this sector?
A: The first place investors should look is where states and local governments rely on the private sector to provide goods and services. Then they should look for opportunities in highly fragmented markets ripe for consolidation and in underpenetrated markets where governments are likely to increase spending.
Here are some areas we find particularly attractive:
- Outsourced services. State and local governments are increasingly outsourcing non-core functions to the private sector. A perfect example would be the increasing use of charter aircraft by state governments for fire suppression. It makes perfect sense for a private company to provide this kind of service.
- Transportation infrastructure, including road maintenance, paving, construction, engineering services, worker and contractor compliance platforms, and testing, inspection, and certification.
- GovTech, particularly smaller government entities that need to update their legacy and paper-based systems to cloud-based platforms.
- Compliance platforms. Government spending comes with all sorts of paperwork requirements, ranging from prevailing wage compliance to occupational health and safety. States also have to adhere to all sorts of compliance requirements whenever they use federal funds.
Q: What are the risks to investors?
A: The risks to government revenue. Without sufficient funds coming in, state and local governments have to start looking at how to adjust their budgets to stay in balance. Budgets are an expression of policy, and when policy priorities change, investors are exposed to changes in spending on specific needs.
Longer-term issues we keep an eye on that can have a significant impact on a government’s fiscal health include:
- The funding status of legacy liabilities like pensions and post-retirement health plans and how the cost of supporting them will grow over time.
- How collective bargaining agreements that typically include cost-of-living adjustments (COLAs) will impact budgets over the life of the agreement and drive up wages.
- How the deferral of maintenance projects, major decisions surrounding IT modernization, or capital investments could impact critical infrastructure, basic services, or budgets in the future.
- Revenue volatility from peak to trough during an economic cycle, something that is often not taken into consideration when long-term financial decisions are made by policymakers during periods of prosperity.
Q: What other developments are you watching?
A: In the short term, we are monitoring states that have trouble passing budgets. We watch for the major points of disagreement on spending and taxes and what it could mean for funding.
Over the longer term, we monitor Congress and its work on passing budgets and reauthorizing legislation such as the Infrastructure Investment and Jobs Act (IIJA), a funding package for surface transportation. It is huge for companies exposed to the construction, operation, and maintenance of roads, bridges, and transit systems.
Federal funds are incredibly important for state and local governments and make up a large source of support for social services, healthcare, housing programs, state departments of transportation, and education. So our interest extends beyond IIJA to other kinds of appropriations, depending on which federal funds a specific company is most exposed to. Transportation tends to be one of the biggest, after healthcare and education.
Q: Where might legal challenges emerge that derail expected outcomes?
A: We have been observing federal challenges to state policies that manifest in one of two ways: (1) a change in regulations impacting a program that is an important source of funding, or (2) federal efforts to unilaterally de-fund certain programs that states rely on. This often results in litigation, particularly if aggrieved parties believe a federal agency is exceeding its legal authority.
One example is the cancellation of the Promoting Resilient Operations for Transformative, Efficient, and Cost-saving Transportation (PROTECT), a small program benefiting state transportation departments designed to support investments in resiliency that the Trump administration felt was too green. We have seen similar attacks on funding for electric vehicle (EV) charging stations, renewable energy projects, disaster response and hazard mitigation funding, and some grant programs benefiting sanctuary jurisdictions that refuse to cooperate “sufficiently” with federal immigration policies.
Q: What is the Trump’s administration’s actual policy prioritization vs. the rhetoric?
A: The Trump administration’s views on policy are sometimes quite inflammatory, but the reality is that agencies often have to approach things incrementally. For example, Trump has effectively signaled he would like to completely revamp how disaster funding is handled and get the federal government out of the business of being the primary source of recovery funding after a big disaster.
The problem with this plan from the White House is that federal law governs disaster funding, and the Federal Emergency Management Agency (FEMA) has an obligation to fund eligible expenses for declared disasters up to a 75% federal cost share. So what Trump can change unilaterally is, for example, determine at what level of severity of damage a disaster is eligible for federal funding, what kinds of expenditures for a specific disaster are eligible for funding, how closely FEMA will scrutinize how funds are spent, and to what extent the White House is willing to go above that 75% cost-share threshold. However, making wholesale changes to how funds are allocated and to what extent Congress should provide funding—that all requires legislation.
Read more from Matt and Capstone’s Special Situations team:
TSA Privatization Opens the Door for Private Security
State Budget Squeeze: Why States are Running Out of Breathing Room
When State and Local Revenue Falls and Federal Funding Disappears
