How Federal Infrastructure Spending Can Close the Racial Wealth Gap
Below is the Nowak Metro Finance Lab Newsletter shared biweekly by Bruce Katz.
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June 9, 2021
(co-authored with Keith Bethel, Jamarah Hayner, Rick Jacobs, Colin Higgins and Andrew Petrisin)
Last week, in Tulsa, the Biden Administration announced a raft of steps they will take to close our country’s widening racial wealth gap. Central to the Administration’s wealth-building agenda are twin executive branch actions to reduce discrimination in home appraisals and to increase the targets for direct federal procurement from small and disadvantaged businesses (DBEs) by 50%, or $100 billion, over 5 years. These are laudable, bold and necessary moves.
To have the needed impact, especially given the imminent federal investments through the American Jobs Plan, we see reforming the way that that government — at all levels — contracts for building infrastructure as a necessary and urgent task. If done right it will be truly transformative. However, it will not happen by itself and now is the moment to act.
We have been working with the Irvine Foundation and the Philadelphia Equity Alliance, with support from McKinsey, for the past six months to understand the current state of procurement practices in Los Angeles and Philadelphia. Our conclusion is that the current system needs an overhaul. This can only be accomplished through institutional reform, legislative focus and directed funding.
Simply put: Procurement reform is not just a matter of increasing spending targets. It requires wholesale institutional change.
We applaud the Biden Administration’s announcement of new targets as a step to overhaul key and highly leverageable tools of the federal government that are long overdue for reform. In this spirit, we provide some key reforms Congress can take to make even more substantial, complimentary, progress.
Federal infrastructure spending offers a unique platform for growing Black- and Brown-owned businesses and building wealth in disadvantaged communities. It has a unique combination of symbolic importance and market-making potential that make it one of the highest impact interventions. Infrastructure policy has a legacy of destroying Black and Brown wealth in America — infamously through the construction of highways in the name of “urban renewal” in the 1950s — and must be part of the solution for rebuilding that wealth.
Federally funded infrastructure is market-making on all levels. On the macro-level it represents a public bet on what places, industries, and activities will shape the future. On the micro-level, it represents a huge demand-boost for private sector firms, since the government will not build the infrastructure itself. Infrastructure agencies will buy a plethora of goods and services to deliver federal investments. Architecture and engineering firms will design projects. Construction firms will build them. Other firms will maintain them, once built. This will create not only jobs but will also build wealth for the firms that are contracted to build infrastructure. Failing to reform federal procurement at this moment represents a missed opportunity of generational proportions to close the nation’s wealth gap.
Federal infrastructure spending is already underway, and more is likely to come soon. The American Rescue Plan Act (ARPA) has already appropriated $126 billion for investments in elementary and secondary schools, which can be used for substantial renovations of school facilities (such as HVAC system replacement) to enable safe reopening in the face of the COVID-19 pandemic. The proposed American Jobs Plan goes further, recommending unprecedented investments in a broad array of infrastructure, including: transportation (e.g., roads and bridges, public transit, passenger and freight railways, airports, waterways and ports), buildings and utilities (e.g., affordable housing, high speed broadband, electric grid, water/sewer, public schools) and disaster resilience. Significantly, some of the proposed funding is explicitly intended to repair the damage of prior infrastructure investments that divided cities and segregated minority communities through the destructive building of highways. As the American Jobs Plan moves through congress, it provides an important and logical vehicle to advance reforms that help the Administration close the racial wealth gap.
The moment is now: A powerful tool overdue for reform
The federal focus on equitable procurement has been in place for decades, but its impact has fallen dramatically short of aspirations. In 1983, Congress enacted its first disadvantaged business enterprise (DBE) provision, ensuring that infrastructure projects receiving US Department of Transportation (USDOT) funding allocate 10% of their spending to certified DBEs. This most-often occurs through a sub-contracting relationship —where DBEs do one, frequently low-profit, element of a project, while the prime contractor keeps the bulk of the contract. The program, designed decades ago for family-sized businesses, simply has not kept pace with the changing small business landscape. Other than a change to include women in the definition of DBE, the program has not significantly changed in the nearly 40 years since it was established. It leaves DBE subcontracting as a box to check and ensures that Black and Brown-owned businesses stay small and attached to the program.
The use of federal procurement as a tool to close the racial wealth gap seems to have flown under the radar for legislators. However, the barriers that have hindered substantial procurement reform in the past have changed in the past year. In anticipation of the largest infrastructure bill in a generation and in the wake of the largest mass movement for racial justice in the nation’s history, it is time to revisit the power and potential of equitable procurement in infrastructure.
Five Fundamental Challenges to Address
Small business procurement is overdue for an overhaul. Largely out of benign neglect, the current programs have set up a financial and institutional structures that keep disadvantaged firms at a disadvantage from start-to-end of the federal contracting process. These issues are especially pronounced in infrastructure because of the large contracts and institutional complexity of contracting. In the recent past, reforms have nibbled around the edges with unified certification in MAP-21, limited personal net worth and gross receipts changes, and SBA-conformance in the FAA reauthorization; however, reformers have done little to address the systemic challenges facing minority-owned businesses. This has created five foundational challenges that any reform to supplier diversity must address.
Challenge 1: DBE firms are at a disadvantage when accessing the flexible capital they need
DBEs do not have access to the same financial system majority-owned firms do. Federal programs have been limited in the scope of the problem they’ve addressed. Whether it’s raising a first round of capital, building long-term capital reserves, or raising capital to quickly staff-up and mobilize for a project, raising funds is more difficult as a DBE. Federally backed programs statutorily provide DBEs with financial products less sophisticated and less supportive than those accessed by majority-owned firms. Even if a minority-owned business has the relationships, track record, and balance sheet to access capital, that capital is frequently provided via inflexible debt products.
The US Department of Transportation’s Short Term Lending Program exemplifies this issue. It offers debt capital but puts severe limitations on its use. This puts the very businesses this money aims to help at a structural disadvantage compared to majority-owned firms who can raise more flexible funds. The Trump Administration discontinued the program, meaning it’s due for a refresh under the Biden Administration; we would encourage additional flexibility. If DBEs are going to thrive, we must remove barriers like this and develop new financial products that address the financial disadvantages faced by the firms rather than reproducing them.
Challenge 2: Current procurement and contracting incentives inhibit growth
Procurement is where the rubber meets the road in supplier diversity. USDOT’s existing 10% federal set aside for DBEs has inadvertently created an incentive system for minority-owned business to “get certified and stay certified” rather than “get certified and grow.” Businesses with gross receipts that surpass $26.3 million seeking contracts through the DBE program are stuck between a rock and a hard place: they are too small to compete with larger firms and too large for federal set asides. (In infrastructure projects that often run into the billions, total revenue of $26.3 million is a rounding error. It may sound like a lot, but when considering gross revenues, it is not.) As currently constructed, the 10% set-asides largely confine DBEs to subcontracting roles, meaning less project work, narrower operational margins, and less experience to someday exit the program competitively. In addition to this, the personal net worth cap for entrepreneurs participating in DBE programs has not been inflation and does not account for geographical variance (despite the wide variation in cost of living across this country). If we care about closing the racial wealth gap, then we need to update how we contract for infrastructure projects, starting with addressing the incentives that inhibit growth in DBE set-aside programs.
Challenge 3: The Fragmentation of Public Entities causes excessive administrative burdens
Federal infrastructure spending will flow to a balkanized set of special, often independent, public entities including school districts, city agencies and public authorities who will in-turn procure specific contracts from firms. To-be-released McKinsey research in Philadelphia reveals that these entities have different definitions of DBEs (as well as differing lists of DBEs), use separate processes for procuring goods and services and engage (or fail to engage) with different stakeholders in the ecosystem, including entrepreneurial support organizations and financial institutions. There is no unified approach to supplier diversity, meaning that the whole is less than the sum of the parts. In addition to the institutional issues this creates, it also leaves DBE firms filling out excessive — often duplicative — paperwork to qualify for similar contracts with different agencies.
Challenge 4: Certification has High Transaction Costs
The process of getting and staying certified as a qualified DBE or Minority Owned Businesses (MBEs) is overly burdensome for many historically underutilized firms. Despite recent improvements that streamline the certification process and increase reciprocity across state-lines, certification is often cited by disadvantaged businesses as one of the highest hurdles to participation in public contracting. This is both because of the administrative burden and lack of technical assistance to meet cumbersome, redundant, and sometimes conflicting certification and compliance requirements — especially considering that certifications often vary by agency and by state. Frequently, the staff time or outside professional services support needed to complete certification paperwork rivals the amount of effort required by the largest prime contractors, which have greater resources — by many orders of magnitude — to afford backend operations. Many of these burdens stem from well-intentioned efforts to support historically underutilized businesses and are now perversely limiting their access to contracts. Fortunately, the direly-needed reforms to certification are high-impact and can be accomplished with relatively-low effort by agency leadership.
Challenge 5: Lackluster transparency in enforcing DBE targets sets up conflicts of interest and erodes trust
The current federal process for meeting DBE goals relies on a system that lacks transparency and suffers from poor enforcement. This erodes trust, creates bad data, and is self-defeating. There are two areas where this problem is most pronounced. First, for each project funded by the federal government, prime contractors must undergo a “Good Faith Effort” to find a DBE that can meet the project’s DBE goals. These efforts mean, in essence, that the prime contractor has tried their best to solicit bids from DBE firms. Often, prime contractors report that there are no small and minority-owned firms that can do the work. This claim is often incorrect, but no countervailing structure exists to validate prime contractor reports. If no suitable DBE can be found through a good faith outreach effort, the prime is granted a waiver to self-perform the work in the contract. The lack of transparency in good-faith efforts often erodes DBE trust in the “good faith” of the efforts.
Second, firms selected as DBE sub-contractors are often recipients of support programs such as mentor-protégé, which are focused on growing business acumen. These programs are set up so the prime mentors the subcontractor on operational tasks like setting billable rates — which the sub-contractor then uses to bill the prime— and business planning to grow into vibrant firms that compete against the prime. The problem here: there is a deep conflict of interest at the heart of these programs, which require primes to negotiate against their own bottom line. On top of this, there is limited transparency into the treatment and outcomes of subcontracted partnerships for Black- and Brown-owned firms that partner with larger majority own suppliers, contributing to an erosion of trust in the DBE program’s commitment to wealth building.
Five Federal Reforms for Closing the Racial Wealth Gap Through Procurement
The challenges facing DBEs and Historically Underutilized Businesses (HUBs) are structural. They require structural fixes to federal procedures, practices, and programs. Below we outline five top-priority federal reforms — three are legislative, one is executive, and one is a joint effort — that begin to address the challenges highlighted above.
REFORMS TO INCREASE ACCESS TO CAPITAL FOR DBE FIRMS
Federal Reform 1 (legislative & executive): Change statutes to allow federal intermediaries to offer flexible equity financing and forgivable loans
We have one capital market for majority firms who can access a variety of financial products, and a separate, smaller and more rigid, market for DBE firms. We simply propose to level the playing field. Congress should work with the Administration to change statutes so that federal intermediaries such as Small Business Transportation Resource Centers (SBTRCs) can offer a mix of equity and debt products through their participating lenders. We should also take lessons learned from the PPP program, and offer forgivable loan products for project mobilization. States can also deploy supportive funding to support innovative and flexible capital products for this aim through the State Small Business Credit Initiative. Access to these types of financing products also support minority-owned businesses to have a bond-ready balance sheet, and make long-term investments in their businesses, and our country’s, future.
Challenges addressed: 1
Federal Reform 2 (legislative): Update prompt payment statutes to “pay before paid” to ensure small businesses have enough working capital
Prompt payment for completed work is an industry-wide challenge. This pain is felt most acutely by small and minority-owned businesses. Existing statutes require prime contractors to pay their subcontractors, often including minority owned businesses, 30 days after they are paid. Many local agencies have a shorter timeframe of around seven days. Congress should move forward by changing existing federal statutes to a seven-day window to pay when paid or move to a “pay before paid” model where subcontractors will be paid before primes are, i.e., the well-capitalized primes will front the money to the subcontractors. Legislators should also explore models that allow contracts to be awarded with 15- to 30- day payment advances to improve the working capital for small business owners — a practice often used in the private sector to support cashflow.
Challenges addressed: 1, 5
REFORMS THAT REMOVE PERVERSE INCENTIVES FOR DBES IN PROCUREMENT AND CONTRACTING
Federal Reform 3 (legislative): Unbundle Projects and Enable Direct Contracting
Unbundling projects and enabling direct contracting will incentivize small and minority owned businesses to not stay small but to “get certified and grow.” It will do so by providing: (1) access to prime contracting opportunities; and (2) a long-enough runway for firms that grow beyond gross receipts of $26.3 million to exit sheltered bidding programs and thrive in an open bidding environment. Direct contracting sets aside certain sizes of projects for small and medium sized businesses, facilitating prime contracting opportunities for these firms. By unbundling projects, the federal government will allow small firms to bid, increasing the competitiveness of bids ultimately at a lower cost to the agency. There is early movement around these issues on the Hill, with Senator Alex Padilla discussing the challenges of making the small- to medium-size business jump at the recent subcommittee hearing, Equity in Transportation Infrastructure: Connecting Communities, Removing Barriers, and Repairing Networks Across America.
Challenges addressed: 2, 4, 5
Federal Reform 4 (legislative): Adjust the Personal Net Worth Cap for inflation
The Personal Net Worth (PNW) cap, a requirement to qualify as a DBE, has not been raised in over a decade and directly inhibits efforts to close the racial wealth gap by punishing successful entrepreneurs of color. Congress and the administration should raise the PNW cap from $1.32M to where it would have been if it had been inflation adjusted ($1.52M) and tie it to inflation moving forward. Congress should also change statutes so the DBE program follows the same PNW calculations as SBA programs, excluding long-term retirement accounts from consideration. Currently the system is set up to disincentivize retirement savings for successful DBEs seeking to maintain competitive bidding status.
Challenges addressed: 1, 2
REFORMS THAT INCREASE THE ADMINISTRATIVE EFFECTIVENESS AND EQUITABLE OUTCOMES OF DBE PROCUREMENT
Federal Reform 5 (executive): Focus an Interagency Task Force on Developing A Unified Supplier Diversity Unit
The federal government currently has several local and regional intermediaries (the SBA’s Small Business Development Centers, the Department of Commerce’s Minority Business Development Agency, and the USDOT’s Small Business Transportation Resource Centers, among others) to help DBEs access contracts and grow. However, these intermediaries are often underfunded and poorly coordinated with each other — let alone across the federalist landscape of state, local and county agencies they must work with to truly drive business equity in contracting. Often this results in a process that is onerous for business-owners and which has limited impact in closing the racial wealth gap through procurement. As part of their increased DBE procurement targets, the Biden Administration announced that “agencies will assess every available tool to lower barriers to entry and increase opportunities for small businesses and traditionally-underserved entrepreneurs to compete for federal contracts.”
We encourage the Administration to ensure that agencies focus on procedural barriers to equitable contracting. They could do this by building on their already announced first-of-its-kind interagency task force on home appraisal by adding a twin mission of establishing uniformity in the federal contracting process for DBEs. The Administration should require all agency heads participating in the task force to complete two tasks:
1. All participating agency heads should begin, or accelerate, the streamlining of certification and compliance processes and portals, prioritizing user interface for disadvantaged businesses as well as eliminating unnecessary steps such as in-person notarization, when other legally appropriate options are available. These are already well-documented barriers with simple solutions that make sense to implement.
2. All participating agency heads should report back on findings on agency-specific and cross-agency barriers to equitable contracting and recommend solutions within 90 days.
We envision this second task resulting in the creation of a unified supplier diversity unit situated within the White House Office of Management and Budget. This unit would coordinate and centralize the advisory, matchmaking, reporting, and financing functions of existing supplier diversity intermediaries through a single platform.
Such a platform could be modeled off local efforts like that emerging in Philadelphia where we are recommending a new Supply Philly Initiative, designed to steer a substantial volume of federal infrastructure dollars to support, strengthen and grow local Black- and Brown-owned businesses. The Initiative would create a new Supplier Diversity Hub to work with a broad array of infrastructure agencies in Philadelphia to alter procurement practices in the service of business equity. The new Hub would also work in close concert with a new Supplier Diversity Consortium to ensure that potential vendors get the business coaching and quality capital they need to meet procurement demand. The Hub would finally drive the creation of a Supplier Diversity Marketplace, to bring transparency in goal setting and reporting across multiple infrastructure agencies.
Challenges addressed: 3, 4, 5
Meeting the Moment: Closing the Racial Wealth Gap through Infrastructure
In previous decades, the transportation sector has exacerbated inequality, destroyed Black and Brown wealth, and damaged Black and Brown communities in the United States. For the country to truly Build Back Better, America must not only eliminate the continuation of bad practices and remove old physical urban scars; we must also affirmatively contribute to the wealth building efforts of Black and Brown America. The coming American Jobs Plan is both a symbolically and materially impactful way of achieving the Administration’s goals of closing the racial wealth gap through federal procurement. The inverse is also true: an infrastructure package that does not consider Black and Brown construction procurement is blinded to the long shadow of transportation policy in this country, as well as the enormous opportunities that lie ahead. Our country will come up short if, after all is said and done, the Department of Health and Human Services buys 50% more paperclips from Black-owned firms, but little has changed in who is receiving prime contracts for building major infrastructure projects.
Billions of dollars are at stake for historically underutilized businesses to help close our country’s racial wealth gap, but will we act?