May 27, 2025

By Matt Wiederrecht, Head of Capstone’s Special Situations Team

Capstone believes companies and investors are underappreciating opportunities associated with state and local governments (SLGs) spending—particularly in construction, govtech, and outsourced services, where we see a positive policy backdrop emerging. SLG spending is roughly 5.2% of Gross Domestic Product (GDP), excluding healthcare, welfare programs, and education. However, navigating that spending doesn’t come without risk.

• We see notable opportunities in construction, govtech, and outsourced services given the policy backdrop, consolidation momentum, spending trends, and economic resilience of SLG spending in those industries. State and local government essential services can often only be provided in partnership with the private sector. Typical examples include the procurement of equipment and supplies, the outsourcing of highway construction projects, and Software-as-a-Service (SaaS).
• Excluding healthcare and education-related expenditures, state and local governments still represent more than $1.3 trillion in annual spending. Tens of billions of dollars allocated to IT services and the procurement of both hard and soft goods, all of which are provided by vendors—a notable and growing opportunity.
• Investing in the space doesn’t come without risk. Macroeconomic factors, competing priorities, and federal policy changes are risk factors to SLGs and, by extension, the vendor community—developments Capstone closely monitors. Examples include the disruption of funds due to cuts imposed by the Department of Government Efficiency (DOGE) and the shifting of costs from federal to state budgets resulting from cuts to programs like Medicaid, imposed in the context of extending the 2017 Trump tax cuts.

A Historical Overview on the Growth of State and Local Budgets

SLG spending trends have grown, and so have the opportunities that come with that. Excluding federal transfers, state and local government (SLG) spending across all categories of spending was equivalent to roughly 5% of GDP in the mid-1940s. It grew over the next three decades, consistently staying above 10% since 1982, according to data from the Bureau of Economic Analysis (BEA). This increase in state and local spending as a percentage of GDP can be attributed to programs like Medicaid and other social welfare programs established in the 1950s and 1960s, which significantly increased federal grant funding for states. These programs typically require state or local governments that receive the funds to contribute toward part of the program’s cost to qualify for federal funding. This matching fund requirement forced states to expand their budgets to maximize the amount of federal funding they are eligible to receive.

State and local budgets as a percentage of GDP are currently at stable levels, around 13-14% of GDP, and have declined from their peak around a decade ago, as the broader economy has grown faster than SLG spending. The most recent available data from the US Census of Governments showed that expenditures by SLGs equaled $4.3 trillion and revenues equaled $4.5 trillion during the year ended December 31, 2022. The excess revenues generated in 2022 were largely attributed to an influx of assistance appropriated by Congress and the fact that the fiscal year for states and the federal government do not align with the calendar year, which is how this data is collected. These excess revenues were either spent in future years or used to build up reserves against a future economic downturn.

Of the $4.5 trillion in revenues, $1.3 trillion came in the form of federal transfers like grants to fund programs like Medicaid, funding to support state and local investments in transportation infrastructure, and pandemic assistance. The remaining funds came from tax revenues ($2.4 trillion) and other sources of revenue ($913 billion), like user fees. Since 2000, SLG’s own source revenues have risen at an average annual rate of 4.2% due to a combination of economic growth, inflation, and tax increases imposed during periods of fiscal stress. However, this growth has not been consistent as there is often a degree of volatility in specific streams of revenue, like personal income tax collections, which can underperform and even drop on a year-over-year basis during periods of fiscal stress, like the recent pandemic and the 2008-2009 recession.

In examining how SLGs spent $4.3 trillion in 2022, $3.7 trillion could be attributed to funding current operations across all the various functions that SLGs perform, such as providing K-12 education, Medicaid coverage for low-income individuals, and basic local government services like waste collection and police protection. An additional $429 billion was spent on capital investments, including the paving of roads and the construction of schools. The remainder, which represented less than $200 billion, was for interest payments on outstanding debt and miscellaneous assistance and subsidies, which were not categorized by the US Census Bureau in the US Census of Governments data.

In 2022, approximately 32% of the $4.3 trillion in SLGs spent was on education (K-12 and higher education), and 34.7% was tied to various state-administered social welfare, healthcare, and income maintenance programs. The remaining $1.3 billion in SLG spending was spread across the other categories of expenditures (see Exhibit #1). These other categories include but are not limited to transportation (6.3%); public safety (7.8%); Governmental administration (4.8%); the environment and housing (6.2%); and miscellaneous expenditures not categorized by BEA (8.3%).

Exhibit #1: State and Local Government Expenditures in 2022 by Category of Spending

Capstone finds the following areas of government spending to be particularly attractive:

Construction

According to the most recent data on construction activity from the US Census Bureau, the total public sector construction is running at a seasonally adjusted annual rate of $508 billion per year as of March 2025, and most is funded by state and local governments with highway and street work representing 30% of this amount. Education represents 22%, and water and sewer work represents 16% of public sector construction spending, respectively. Public sector construction is incredibly resilient and can even increase in periods of economic weakness. The construction market is also highly fragmented and a prime candidate for consolidation as most contractors are owned by founders, operate in local or regional markets, and would benefit from larger economies of scale.

GovTech

According to e.Republic, GovTech as a product category represented almost $150 billion in SLG spending in 2024 and has grown above the rate of inflation for years, with some specific product categories experiencing double-digit annual growth rates. Governments increasingly are turning away from proprietary IT solutions and toward the private sector for ways to improve efficiency. Given the fact SLGs are often shifting from paper-based or proprietary IT solutions to outsourced solutions and this market is highly fragmented, we believe this market will experience both significant organic growth and is also a prime candidate for consolidation.

Outsourced services

SLGs are increasingly outsourcing non-core functions to the private sector to save money and improve the delivery of services. Budgetary and staffing constraints often prompt SLGs to find ways to do more with less, and outsourcing is one way local governments can expand services without significantly increasing the budget. Examples of outsourced services include hiring contractors to provide building inspection services, updating tax maps, landscaping services, and using a private company to tow illegally parked vehicles. Most of these services are also provided by smaller local and regional businesses that likely could be consolidated into a larger platform company that would benefit from increased scale, serving a market like the SLG market that represents a relatively stable source of revenues.

Why SLGs Need the Private Sector

States, counties, cities, and smaller municipalities often turn to the private sector to help deliver essential services to the community. This assistance can take the form of contracting with a vendor to provide equipment and supplies to a local public works department or bringing in a third party to transition a city’s permitting system to a software-as-a-service (SaaS) platform that manages public records, processes applications and permits, and automates workflows throughout the department. It is also common for state and local governments to either completely privatize some functions, such as the operation of vehicle emissions testing stations and the management of, and sometimes even the ownership and operation of, infrastructure that provides essential services like clean drinking water, wastewater treatment, and solid waste disposal.

A few reasons why SLGs turn to the private sector are as follows:

• Private companies tend to operate more efficiently than the government can and have far more flexibility in terms of their hiring practices, operations, structure, and ability to adapt to changing conditions and circumstances.
• The government often lacks personnel with the necessary skills to perform specialized tasks, and this is particularly true with smaller units of government that are more resource-constrained. Construction is a prime example of a task that is typically outsourced, as SLGs lack the expertise necessary to manage and deliver construction projects more complex than road resurfacing, and even then, only larger cities and counties handle those tasks internally.
• The private sector often can deliver solutions like a new IT system or the repaving of a road faster and cheaper than a government agency or municipal government can.
• SLGs can shift risks to the vendor community and leverage their capital and human resources by outsourcing certain functions. The leasing of hard assets, such as trucks, is one example of how the public sector can utilize the balance sheet of private sector partners.
• Governments must typically operate with a balanced budget, so turning to solutions like software-as-a-service, paid for on a subscription basis, as opposed to developing, owning, and operating a proprietary IT solution, is a perfect example of how an SLG can continue to ensure basic services are provided while staying within budget.

Why the Public Sector is an Attractive Target Market

The public sector is an incredibly attractive market for companies of all kinds in the private sector, given its size. Part of the reason stems from the fact that there are tens of thousands of local governments of all sizes across the country, all with common needs that are largely unable to be met without the assistance of the private sector. Examples of these needs that the private sector asked to provide to the public sector include construction services, professional services, the collection and disposal of solid waste, and even the management of municipally owned water and wastewater infrastructure.

The public sector is also attractive as a market for several other reasons, including the following:

• SLG budgets are relatively stable, with a healthy base of revenues, so there is less credit or business risk associated with SLGs as customers compared to those in the private sector.
• It is also not unusual for SLGs to enter multi-year contracts and long-term relationships with preferred vendors, which means this customer base should be viewed as somewhat “sticky” with higher-than-normal retention.
• And finally, SLGs cannot choose not to provide basic services to residents during periods of fiscal stress, so if a vendor has a contract to provide this service on behalf of a local government, that contract is likely somewhat insulated from any fiscal stress being experienced by its customer. In the private sector, a business under serious financial stress is at risk not only of insolvency, but also of liquidation.

Risk Factors

While state and local governments present a large and attractive market to a wide variety of businesses operating in multiple industries, this market faces various political and economic risks that investors should be mindful of. These risks can be broadly grouped into three categories, which we would describe as more macroeconomic in nature, tied more specifically to the federal government, and tied more to the budgetary health of individual state and local governments. Most of these risks are either directly or indirectly related to SLG budgets, which should be viewed by investors as a statement of policy outlining the government’s priorities and how finite resources are allocated across competing priorities.

Macro Risk Factors

With respect to macroeconomic risks, we would highlight the risk of economic uncertainty and cyclicality as well as risks associated with interest rates, inflationary pressures, and unemployment. Non-recurring events, such as pandemics and disasters, would also be considered macroeconomic risks, as would demographic shifts like population aging and declining birth rates.

Federal Risk Factors

The current political environment in the District of Columbia highlights the potential risks that SLGs and investors face from the federal government. Under the Trump administration, we have seen changes in federal priorities and cuts in the flow of grant funding to SLGs across various federal programs. The Department of Government Efficiency (DOGE) and its impact on both federal agencies and the grant programs they administer are a perfect example of the impact changes in federal priorities can have on the recipients of those funds, some of which are state and local governments.

Congress is also actively considering permanently cutting funding at various federal agencies and decreasing the federal cost share for programs like Medicaid, which are federally funded but administered by the states. There are even proposals to impose unfunded mandates on states, such as shifting part of the cost of the Supplemental Nutrition Assistance (SNAP) program, which is currently 100% paid for by the federal government, onto state budgets, or eliminating the Federal Emergency Management Agency (FEMA) and making states responsible for paying for the cost of disaster recovery efforts within their borders.

Local Government Risk Factors

Vendors to SLGs also face risks specifically from the state and local governments with which they do business. Examples of these kinds of risks include local economic conditions within the community and the resulting impact on tax revenues, as well as the specific kinds of tax revenues an SLG is dependent on and how that source of revenue performs during a period of financial distress. Another risk factor worth noting is the level of reserves a state or city has on hand to deal with emergencies and to what extent are specific sources of revenue like fuel tax revenues protected through lockbox arrangements or the state’s constitution being raided and used for purposes other than for funding roads by a state or city. And finally, investors should be highly aware of any limitations other fiscal policies place on SLGs, including limitations on the issuance of debt, balanced budget requirements, and the extent to which tax increases are restricted either by law or the state’s constitution.

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