From our CRE Service Delivery and Outsourcing Thought Leader Contributor, EY.

EY Corporate Real Estate Transaction Services

Exploring site separation during divestitures

By Michael Golichowski, EY Americas S&T Corporate Real Estate Transaction Services Solutions Leader; Nicholas Tatro, Senior Director, EY-Parthenon, Ernst & Young LLP; Eva Heddergott, Senior Director, EY-Parthenon, Ernst & Young LLP; Petar Torlak, Director, EY-Parthenon, Ernst & Young LLP; Bradley Gaulden, Director, EY-Parthenon, Ernst & Young LLP

As the landscape of modern business continues to evolve, organizations face the constant pull of change and transformation, compelling them to reevaluate their assets, strategies and operations. Mergers/acquisitions, divestitures and reorganizations are no longer isolated events, but rather integral components of a firm’s overall evolution. In this publication, we will explore the requirements, challenges and benefits encountered while developing strategies to effectuate a divestiture viewed through the real estate lens.

The record number of M&A transactions in 2022 and 2023 speaks to the need for a thoughtful site separation strategy. Deals often result in significant rapid shifts in a company’s real estate requirements and may cause disruption in the operating model. Therefore, business leaders must understand how to drive portfolio value, minimize stranded costs, reduce Transitional Service Agreements (TSAs), and maximize synergies. From the initial planning stage to actual execution, real estate plays an integral part, facilitating the role of a key downstream and upstream function, imperative to avoiding operational disruption and extra costs.

Given the current economic conditions and not-so-promising outlook, many corporate leaders are embracing the aftermath of a series of “once-in-a-lifetime events” that have shaken the world over the last several years as opportunities to reframe corporate objectives. A weakening labor market and increased projected unemployment, resurfacing inflationary pressures, rising debt levels, recent bank failures creating uneasiness in financial markets, and a persistent risk of a recession are just some of the reasons why corporations should ensure lean and sustainable operations. As the second-largest item on the balance sheet and a hedge against inflation, now, more than ever, real estate should be central to any strategic planning and throughout the deal lifecycle. Following are some key topics for business leaders and deal managers to consider:

Real estate is a critical component to any corporate transaction

Just as IT, HR and finance are important functions that require consideration early in the negotiating process to help ensure business continuity, real estate is a piece of the divestiture puzzle that needs to be discussed early and often. The value of doing so becomes apparent as leaders evaluate synergy targets and develop strategies to optimize the future of the company in whatever new form it will take. When companies engage in transaction activity that involves different business units and real estate properties, issues tend to arise as to property ownership and responsibility. Today, most companies have adopted a very active divestiture mindset. They are taking a hard look at their non-core assets and evaluating them for viability to spin off or carve out to drive value. Often, these assets are determined to be worth more as a stand-alone business than as a subsidiary. Delaying the conversation about all these variables, and about what will change with each company’s real estate portfolio through divesting activity, is a substantial risk.

The divestiture of real estate assets can have a significant impact on the company’s financial performance and the financial metrics of the M&A activity.

Companies need to understand the types of real estate assets being divested, as well as their location, as both will have a significant impact on the overall divestiture process. For example, a manufacturing location in Europe will have significantly different considerations than an office located in Brazil. Additionally, the valuation of the real estate assets, as well as the timing of the divestiture, will need to be carefully considered. This will determine the proceeds of the divestiture, depending on market conditions that could affect the sale price. Tax is another key consideration when divesting owned properties. Engagement with local tax and legal representation is imperative to understand the pertinent tax liabilities. Therefore, proactive analysis of real estate synergy and separation costs can help both the buyer and seller avoid headaches, and ultimately deliver a better outcome for both sides.

The decision to separate is a complex undertaking that demands careful evaluation of the benefits and challenges.

The importance of thorough planning, evaluation of the spin timeline, asset types and volume of assets to be separated is paramount for a successful separation. A well-informed, comprehensive approach to decision-making should consider all aspects of the divestiture process. This will help mitigate risks and maximize the long-term benefits for both the divesting entity and the newly independent organization. Therefore, an in-depth analysis regarding strategic planning, legal compliance, timely business transformation/optimization and communication is critical in successfully navigating this complex process.

The pandemic has shifted our view of how facilities should be utilized, from everyday work to a focus on bringing teams together for collaborative efforts. Workplace experience is now pointed at providing flexibility, choice, and alternatives in response to daily headcount fluctuations. Real estate became a blend of sustainable physical spaces and virtual experiences, enabled through technology, with a purpose to support inclusion and socialization and enhance employee wellbeing. Facilities now provide employees access to collaborative, flexible, meaningful, and engaging workplaces that attract and retain talent. They can also support positive employee experiences where individuals and teams feel connected, productive and safe. However, with the “return-to-work” policies many companies have implemented, there is a constant dilemma on how to preserve company culture and team morale while minimizing operating costs and maximizing portfolio efficiency. Initiating transformation activities early can help address this concern. After all, hybrid working is about meeting employee needs, not growing remote working.

Understanding site separation

Before we examine the pros and cons of separation, it is important to understand what site separation actually means.

Here are a few basic questions to frame our discussion:

• What are the physical, legal, regulatory and operational factors that impact facility site separation?
• Who is impacted by the decision to separate a site?
• How does site separation impact real estate costs?

Site separation in Corporate Real Estate refers to the process of dividing or allocating physical spaces within a larger property or facility to accommodate different departments, functions, or business units of a company/especially during an M&A event such as a sale, carve-out or tax-free spin. It is generally viewed as a tool for larger sites with significant populations within the two new companies. Given the complexities outlined below, it is typically used in settings where a large portion of the space would otherwise sit vacant and create stranded cost. For smaller employee groups, there are strategies that are often more efficient, such as relocating to a nearby site that is dedicated to the respective business, relocating to a serviced office, or if the employee count is small enough and the operations allow, moving to a remote work situation. Several factors influence the design and implementation of site separation, including the nature of the business, organizational structure, the type of work being done in the space, service agreements post-separation and future growth projections. Other considerations are driven by the nature of the space itself, i.e., open vs. closed spaces, internal staircases, access to common areas/amenities, employee health and safety (EHS), accessibility and technology infrastructure. All these factors will be explored in greater detail in the subsequent sections of this paper. Understanding site separation.

What are the physical, legal, regulatory and operational factors that impact site separation? The first and most important factor to separation is determining if separation of the existing space is physically feasible. Those physical aspects are mostly driven by the design, layout and functionality of the spaces within the larger property. A challenging layout may remove site separation as a viable option due to costs or physical limitations. Access to amenities and conference areas are often a topic, but they rarely inhibit space separation. Digital limitations should also be considered when separating a space, as the inability to separate the IT or digital network of a space can be a barrier to separation.

Legal aspects of separation first require alignment on which legal entities are owned by the separating entity, and understanding what leases or owned properties are held by out-of-scope entities requiring legal action to change ownership. This would involve reviewing consent and assignment requirements in lease agreements, coordinating with local jurisdictions on transferring legal title, assigning service provider contracts, and adjusting the scope to align with the new legal owner. It is common to sign a sublease or transitional service agreement with the business being separated in cases where the landlord does not want to take on the main lease or separation is not achievable prior to Day 1. It is important to consult tax professionals as moving owned property may incur a tax liability.

From a regulatory perspective, obtaining the necessary permits and approvals for both physical and legal separation can become a major obstacle for site separation, given the time it may take to resolve and the numerous approvers who must sign off on plans. Regulatory compliance is generally unique to each country and may differ between local jurisdictions, such as state by state or even city by city. A typical example, and often the most time-consuming, is compliance with employment regulations, such as European Works Council (EWC) consultations and sign-offs when separation activities impact employees. Close alignment with tax and HR professionals, as well as local legal counsel, is crucial in navigating these unique regulatory approvals.

Operational aspects focus on the smooth functioning of the separated spaces and the people working within them. Avoiding any kind of business disruption is key to a successful separation while still enabling communication and collaboration — within the new businesses only. Badging, access control and network access are some of the factors.

Who is impacted by the decision to separate a site? To be able to develop a suitable execution and change management plan, you need to understand the various impacted stakeholders within an organization.

Here are some of the key groups that may be impacted by such a decision:

• Employees are directly affected by the physical separation of a site through either relocation, or disruption during construction.

• Human resources (HR) teams are responsible for ensuring that the separated spaces comply with labor laws, health and safety regulations, and accessibility requirements.

• Local facility managers oversee the logistical aspects of the separation, including construction, maintenance and security.

• IT teams play a crucial role in setting up the necessary technology infrastructure.

• Legal and compliance teams are responsible for ensuring that the site separation adheres to applicable regulations and lease agreements. They must also address any legal implications related to data privacy, intellectual property and contractual obligations.

• Finance teams need to allocate budgets for renovations, furniture, equipment and ongoing maintenance.

• Local regulatory authorities may need to approve certain aspects of the site separation, especially as it pertains to tax-free spins.

• Customers/vendors visiting the organization may also be impacted by the site separation. It’s important for organizations to understand the needs of and input from these various stakeholders developing and implementing site separation strategies. Cross-functional communication, careful planning and addressing the specific requirements of each group are critical to a successful transition and positive outcomes for all involved parties.

How does site separation impact real estate costs? The extent of the financial impact of site separation depends on various factors such as the scale of separation, the degree of current entanglement between the business units, the real estate market conditions and the organization’s specific goals. It’s true the so-called one-time costs often face greater scrutiny. However, right-sizing both portfolios for the respective operations often has a bigger impact on operating cost. This leads to the side question of which of the businesses should be burdened with the “unwanted” properties that cannot be off-loaded before the separation. Another common point of contention is around reduced space utilization at sites where one of the businesses is relocating to another site, the so-called stranded cost.

Given the different cost types, conducting a thorough cost analysis and collaborating with the right real estate and facilities experts can help organizations make informed decisions that align with their financial objectives for the transaction overall.

Benefits to physically separating space

In our experience, full physical separation is often the desired end-state by Day 1, but it’s not always achievable for all entangled properties. Depending on the transaction timeline, the degree of entanglement for in-scope locations and market conditions, fully separating space (or relocating to new space) by Day 1 may not be possible. When physical/operational separation by Day 1 is not feasible, short-term agreements (e.g., transitional service agreements) are often installed in order to provide the time needed to separate at a later date.

These short-term agreements between RemainCo and SpinCo are generally priced at arm’s length and are granted on a case-by-case basis. The requirements and feasibility for physical separation will vary by transaction and industry/sector, but the benefits are universal. Below, we highlight some of those key benefits:

Increased flexibility

If the subsidiary being spun off has its own physical location, it may have more flexibility in terms of how it manages its real estate assets. This could include having the ability to sublease space to other companies or being able to expand or contract its office space more easily.

Regulatory compliance

Certain industries, such as health care and financial services, have specific regulatory requirements regarding the handling and protection of sensitive data. If the subsidiary being spun off is subject to these regulations, having its own physical location may help ensure compliance by providing a more secure environment for sensitive data.

Simplified compliance reporting

If the subsidiary being spun off has its own physical location, it may be easier to track and report on compliance with regulatory requirements, data confidentiality policies and intellectual property protection measures separately from the parent company.

Simplified accounting and reporting

If the subsidiary being spun off has its own dedicated real estate and office space, it may be easier to account for and report on its operations separately from the parent company. This helps streamline financial reporting and improve transparency for investors and other stakeholders.

Data and IP confidentiality

If the subsidiary being spun off has its own intellectual property, having its own physical location may help protect that intellectual property by providing a more controlled environment for research and development activities, and by limiting access to proprietary information.

Brand and identity

During Sell & Separate transactions, both RemainCo and SpinCo are working to position a new brand — and often times a new name — in the marketplace. Having recognizably different, separate locations from one another can help reinforce the companies’ new identity for customers, external investors and employees. Work closely with branding teams and leadership to prioritize the rebranding of highly visible locations.

Case study

New global headquarters

Sell & Separate transactions provide an opportunity for both RemainCo and SpinCo to re-establish their brand and identity. From a real estate perspective, leadership needs to consider the scope and cost of rebranding their real estate footprint, typically with a focus on locations that are most visible to customers and shareholders. Ernst & Young LLP was engaged with a global manufacturer, tasked with facilitating a decision about their future headquarters location: stay in separated space at the existing campus or establish a new global HQ elsewhere? Ultimately, the client elected to relocate and establish a new global HQ. The driving factor behind this decision was to further cement their new brand and presence in the market with distinctly different space from RemainCo.

Challenges to physically separating space

Physically separating real estate assets can offer a range of benefits in tax-free spin-offs. At the same time, there are compelling reasons for a company to carefully evaluate this decision. These considerations center around potential challenges and complexities that may arise from the physical separation process. This next section sheds light on key challenges that might dissuade a company from opting to physically separate entangled real estate during a tax-free spin-off.

We’ll start by looking at the transaction timeline. The period from spin-off announcement to Day 1 may not provide enough time for the parent and spin companies to complete physical separation. Physical separation may require the subsidiary or parent company to source new real estate in the market, construct physical barriers at existing locations and fit-out the separated space prior to Day 1. Attention to technology infrastructure can add even more time to the process, as it is often tightly integrated with office spaces.

Physically separating real estate may require significant IT adjustments, including network migration, data transfer and software implementation. Ensuring seamless technological continuity while minimizing downtime is a complex endeavor and can be a limiting factor in a company’s ability to physically separate space prior to Day 1. Depending on the complexity of the separation strategy and the IT adjustments required, real estate leaders may need upward of 18 to 24 months to fully implement their site separation strategy.

There is also cost and resource allocation to consider. One significant drawback of physically separating real estate is the substantial upfront costs and resource allocation required. Establishing a separate physical location demands financial investments for leasing, construction, renovation, fitting-out facilities, relocating equipment and personnel, as well as addressing any legal or regulatory compliance requirements. Additionally, human resources and time-intensive efforts are essential to manage the logistical aspects of the move. Such expenses may strain the financial resources of both the parent company and the spun-off subsidiary, diverting funds that could otherwise be directed toward core business activities.

While physically separating real estate assets during a tax-free spin-off can offer numerous benefits, there are significant challenges that might dissuade a company from pursuing this route prior to Day 1. Cost implications, operational disruptions, governance complexity, legal and regulatory compliance hurdles, and resource allocation concerns underscore the need for a careful evaluation of the potential downsides alongside the benefits. A company must weigh these factors comprehensively before deciding on proceeding with physical separation of entangled locations.

It’s important to note that these considerations are general in nature and may not cover all potential legal requirements applicable to physical separation during a tax-free spin-off. Legal requirements can vary widely based on the specific details of the spin-off and the jurisdiction in which the company operates. Consulting with professionals who specialize in corporate transactions and the relevant areas of law is essential to ensure a smooth and compliant separation process.

Operational disruptions

The process of physically separating real estate can lead to operational difficulties for both the parent company and the spun-off subsidiary. Transitioning/moving staff, equipment and operations to new facilities can disrupt established workflows and customer interactions. This disruption may affect productivity, customer satisfaction and even revenue, potentially leading to short-term setbacks in performance and market perception.

Resource allocation and focus

Physical separation demands considerable management attention and resources during a critical period of change. This diversion of focus and resources from core business operations may hinder strategic initiatives and inhibit the company’s ability to capitalize on emerging opportunities or navigate market challenges effectively.

Stakeholder communication

Maintaining effective communication with various stakeholders, employees, customers, investors, regulatory bodies and suppliers during the transition is crucial. Mismanaged communication can lead to confusion and uncertainty, and can potentially damage the company’s reputation.

Legal and regulatory compliance

Establishing separate physical locations may raise legal and regulatory compliance complexities. Certain industries have specific regulations regarding the transfer of assets, data protection, and environmental considerations. Navigating these requirements for two distinct entities could entail legal hurdles, potential delays and increased compliance costs.

Workforce impact

Employee morale and productivity may be adversely affected by the uncertainty and stress associated with a physical separation. Adjusting to new work environments, commuting logistics and potential changes in team dynamics can lead to resistance and decreased employee engagement.

Funding separation costs

Establishing one-time cost guidelines with the Separation Management Office (SMO) early in the transaction process is essential. Clearly communicated funding guidelines enable real estate teams to quickly move from planning to execution against projects with lead times exceeding 14 months.

Case study

Cybersecurity concerns

Temporary agreements allow for an immediate short-term solution for complicated site separation issues. However, proper cross-functional alignment should be achieved to prevent non-compliance to broader separation guidelines.

During engagement to manage the site separation of a global manufacturing conglomerate, numerous locations were identified where separation was not achievable prior to spin Day 1 and temporary agreements were struck to mitigate business disruptions. These agreements outlined access and use terms between the separating firms to allow impacted employees to continue working at the same location until alternative space could be procured. Cyber identified such risks as access to confidential information and sharing of intellectual property of now separate entities.

This resulted in a requirement for complete physical separation at all locations causing significant rework and impact to employees to provide approved working space prior to Day 1.

Conclusion

A well-executed physical separation plan can be a pivotal element in the overall success of the divestiture. It is imperative for business leaders to ensure the separation strategy aligns with the divestiture’s broader objectives and that all key real estate stakeholders are brought in to assist in developing strategic objectives.

Strategic planning should encompass a clear roadmap for executing the separation, outlining key milestones, resource allocation and risk management strategies. By conducting comprehensive due diligence, it is crucial to identify properties that align with the divesting entity’s long-term vision while also considering the future needs and preferences of the newly independent organization. By anticipating potential challenges, developing contingency plans and ensuring close cross-functional collaboration, the process can be made more efficient and seamless, minimizing disruptions and maintaining business continuity.

Similarly, navigating the legal landscape is critical to a successful physical separation. Corporations must ensure adherence to all relevant laws, regulations and contractual obligations related to property transfer and lease terminations, depending on the jurisdiction in which their entities operate. This includes obtaining necessary permits, approvals and clearances to avoid potential legal liabilities that could arise during the transition. In addition, attention should be given to lease agreements to understand their terms, termination clauses and obligations for both parties involved. Careful consideration of these legal aspects should prevent any adverse legal actions and facilitate a smooth handover process. Since divestiture of real estate assets may have significant tax implications and can be subject to regulatory requirements, such as those imposed by the U.S. Securities and Exchange Commission (SEC) and Internal Revenue Service (IRS), it is important to consult with tax and legal advisors throughout the process to understand requirements and comply with them to avoid any legal consequences. Legal compliance is even more pronounced in tax-free spins where the main objective is avoidance of triggering transfer taxes.

It is common knowledge that change is never easy, but it is essential for continuous operations when navigating a challenging economic environment. Therefore, divestiture may be a perfect opportunity to think about transforming the business and streamlining internal processes to ensure continuous and healthy operations on Day 1.

Workplace transformation, including current state assessment through data gathering, stakeholder interviews and data analysis, remote workforce assessment and development of workforce personas can be a challenge. Refinement of futureof-work guiding principles, alignment of future state objectives to leadership vision and development of space profiles can take time, in addition to aligning a footprint to utilization through development of site-by-site business cases and obtaining leadership buy-in. These are just some of the activities that corporations should consider to inform the future state operating model for post-Day 1 operations.

Effective communication and stakeholder engagement are paramount to making the right moves to arrive at a successful separation. All stakeholders should be engaged to provide clarity on the divestiture process and how it will impact them. Transparent communication builds trust and mitigates resistance, promoting a smoother transition for all parties involved. Furthermore, maintaining positive relationships with tenants is essential during divestitures, and offering assistance in finding new locations or negotiating favorable lease terms with the new entity can foster goodwill and encourage tenant retention.

Overall, the decision to physically separate requires a comprehensive and well-structured approach. Strategic planning that aligns with the broader divestiture objectives, legal compliance to navigate the complex regulatory landscape, timely transformation initiatives to ensure smooth operations on Day 1, and effective communication with stakeholders are key elements that can shape the success of the spin. Ideally, stakeholder alignment would play a vital role in ensuring the efficient execution of the separation plan, addressing challenges proactively, and maximizing the benefits for both the divesting entity and the newly independent organization.

The views reflected in this article are the views of the author(s) and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.