14 Chapter 14 Alignment of Interests
Annie set up this system for a very specific reason: Castle and Cooke owns enormous amounts of land. It is a ‘land holding’ company. It is in the business of ‘holding’ land. It is not in the business of operating the any kind of business to make the land create value.
The land Castle and Cooke owns has many different uses. Some is used for golf courses; some for private homes; some for resorts, condos, strip malls, destination shopping malls, marinas, parking lots, electric transmission facilities, and everything else modern people use land for in our 21st century world.
Castle and Cooke doesn’t operate any of these facilities. That is not its business. It is in the business of ‘holding’ land.
Annie deals with the people who will actually go to the land, figure out what it can produce, and make it produce value. These people are going to do things. Castle and Cooke wants the incentives of these operating partners to align with the interests of Castle and Cooke. Annie’s job is to find a way to design agreements with these partners that will align the interests of the partners with the interests of Castle and Cooke.
What are their ‘interests?’
They are basically interested in sending money for shareholders. The money will come from the sale of things the land produces. The company wants the land to produce things with value to people. These things will then get sold or rented or otherwise exchanged for money. Some of this money will have to go to the operating partners who do the actual work. But Annie wants anything that doesn’t have to go to these operating partners to go to Castle and Cooke. Her pay depends on how much money she makes for shareholders. She wants them to do well so she can do well herself.
Annie knows a lot about stock investing. She knows what makes stockholders money. She knows that it isn’t always better for shareholders to have as much money as they can get as quickly as they can get it. She knows that companies called ‘growth companies’ have far higher stock prices (compared to their earnings) than companies that don’t grow. She knows that companies that have stable income have higher stock prices than unstable companies. She knows that if she can set up systems that will give her operating partners incentives to work hard to get the land they control to create value, manage risk well so their income is stable, and improve whenever this is cost effective to drive up their income (and eventually drive up Castle and Cooke’s income), the share price will go up and up, her bosses will be happy and they will show her how happy they are when they decide on the bonus that makes up the bulk of her pay.
Realities of Life
Annie wants the operating partners to have the strongest possible incentives to work hard to make sure everything goes smoothly. If everything goes smoothly for them, they won’t have any problem paying their rents.
But risk is a part of production. Risk is a part of life itself. Things can go wrong. Wait long enough, and something will go wrong. That is the way ‘existence’ works.
Annie wants her operating partners to have so much on the line that they will do everything in their power to prevent anything they can prevent from going wrong. She wants people like Kathy to stay awake at night thinking about things that she might be able to do to make things go more smoothly on the farm and to have backstops in place so that if something does go wrong, she will have the ability to deal with it quickly, before it gets serious.
That is one of the reasons she chose a system that sold a fairly high percentage of the rights to the land. Kathy is buying the rights to a lot of free cash. (The farm produces $2.4 million a year; Kathy won’t own the first $1.8 million of this, she will have to give it to Castle and Cooke as rents. But she will own the right to everything else, which will be $600,000 a year. That is a lot.) Because she was buying a lot, she had to pay a very high price: $12 million is a lot of money.
Every dime of this money is at risk.
If something goes very wrong, she could lose it.
She is willing to take on this risk for a reason: If she can keep things from going wrong, and actually make them go better, she can get rich. If she does a very good job at this, she can get very rich. Since she wants the reward, she is willing to take on the risk. She is going to make her rents a priority. She absolutely must pay them. If she doesn’t pay, she has violated her leasehold agreement and Castle and Cooke can cancel her contract and take away her rights. What happens to her $12 million then? She doesn’t know for sure (in practice it is quite complicated) but one thing she does know is that she won’t have some smiling executive in a suit handing her a check for the full amount. She may well lose millions.
Kathy took out a loan for the money to buy this leasehold, so she isn’t the only one at risk. Her lenders are also at risk. They know it. They are willing to take on risk for the same reason Kathy is: They get rewarded for it. They are getting the interest that Kathy pays. If nothing goes wrong and Kathy pays as promised, they will get $15 million in interest over the course of 25 years. Of course, the lenders know that there are things they can do to manage risk and make it lower. In practice, the lenders will work quite aggressively to manage risk.
Basically, the lenders and the owners are working together to protect Castle and Cooke. Kathy knows that if she can’t make her rents, she will lose her rights to the farm and can possibly lose $12 million. The lenders have put up this money and know that if Kathy loses the farm (because something went wrong that prevented her from making her rents) they won’t get the money back from her. They will lose. They aren’t going to sit back and wait for something bad to happen. They have hired teams of professionals to manage risk and given them budgets that are big enough to do their jobs. (We will look at some specific examples later; here, I just want to lay out the big picture.)
For these reasons, it is extremely unlikely that the rent payment will ever be missed. In this case, the rent payment is $1.8 million. Kathy and the lenders stand to lose $12 million if this is missed. No one would ever miss a $1.8 million payment knowing that, if they do, they are likely to lose $12 million. To protect this investment, people will make sure that the rent is paid. They are acting in their own interests to do this, of course. But they can’t protect their interests without also protecting Castle and Cooke’s interests, because they are aligned perfectly in this case.
Kathy is used to farming land that has been farmland for a fairly long time. Farmers know that crops need water to grow and level land holds water better than unleveled land. Make it level and it will produce more. This is a very easy thing to do and improves yield a lot. If farmers have some time, they go out and move dirt from high spots to low spots. The closer the land is to level, the more it will produce. (Large commercial farms bring in massive equipment and lasers to make the land totally level.)
The land of the Hawaii farm is far from level. There are high areas that stick up above the ground all year long; rice does not grow there at all. There are low spots that are so deep the rice can’t grow. Kathy will have the right to level the land. If she does, she estimates that the land will produce 20% more rice than it does now. The costs will also be 20% higher so the operating profits will be 20% higher and the free cash flow will be 20% higher.
Her rent payment to Castle and Cooke is fixed for 25 years or until the property changes ownership. Kathy will not have to share any of the increase with Castle and Cooke for the foreseeable future.
If she improves, she will actually get two benefits.
The first is the extra money. She will get that for as long as she owns the leasehold or, if she doesn’t sell in this time, for 25 years.
The second benefit will be a ‘paper gain’ on the value of the farm that takes place as soon as the improvement is completed and which she can ‘realize’ (turn from being a paper gain to a actual money gain) any time she wants by selling the leasehold.
She paid $12 million for her rights to this farm. After the improvement, these rights will be worth $14.4 million. She will have made $2.4 million. Her wealth position goes up by this amount as soon as the improvement is complete, but she won’t actually have this money at that time. This kind of a gain is called a ‘paper gain.’ If she wants to turn this paper gain into cash that she can spend, she will have to find a buyer and sell her rights to the farm for $14.4 million. She can then use $12 million to pay off her mortgage and she will be left with the $2.4 million.
Incentives to Improve
If Kathy can increase the operating profits by $480,000 a year, the farm’s market value will go up by $2.4 million. She will not actually get $2.4 million. But she will be worth $2.4 million more ‘on paper.’ The market value of something she owns will be this much higher. If she wants to turn this ‘paper gain’ into real money that she can spend, she has to sell the leasehold.
Annie wants people to buy leaseholds, improve them, and sell them. That is what Castle and Cooke wants to encourage.
It owns immense amounts of land. It started with primitive land with grass huts. It now owns well-developed facilities including mega-resorts, condo complexes with thousands of units, row on row of luxury mansions, electric power plants, office complexes, stores of all kinds, and all of the facilities needed to maintain the lifestyles of the rich that it wants to buy into the projects on the island. It cost hundreds of millions to build all of these things. Castle and Cooke didn’t make these improvements. The leasehold owners did. They planned them. They got the permits. They arranged financing. They brought in the contractors. They hired professionals to monitor everything to make sure it was done right. They got the improvements to a point where they were working and generating free cash flow. Then they sold their rights to someone else. The rents went up and up, from hundreds of dollars per acre to thousands and eventually millions. Our group in Pastland is in a position to form any kind of society we want. We know that in the societies we inherited back in the 21st century, the interests of the people who make day to day decisions about how the world is to be used do not align with the interests of the human race. The human race wants a clean, safe, peaceful world. The people who control land can make themselves very rich by raping it of its wealth and using this wealth to make weapons to ‘conquer’ neighbors.
Their interests not only don’t align with ours, they are virtually the opposite of ours. If they make money, we suffer. This is not a sound way to organize a society. We want certain things. We have certain ‘interests’. Our interests are basically the same as those of Castle and Cooke. We want the land protected. We want it to stay healthy. We want it to produce wealth for our benefit. We want things to go smoothly, with protection taken against risk and potential problems.