On M&A in the Downturn

On October 18, 1999, Nortel Networks announced its acquisition of Clarify Software for $2.1 billion. In a press release, F. William Connor, the president of Enterprise Solutions for Nortel, said: “Together we will provide a new customer experience by unifying the high performance Internet with front office solutions and customer interactions of all kinds. This will deliver greater returns on customer relationships for enterprises and service providers worldwide.”

On October 2, 2001, Nortel Networks announced the sale of its Clarify assets to Amdocs Limited — for $200 million. In a press release, Frank Plastina, president of service provider and corporate networks, said: “We are making excellent progress against the work plan we laid out earlier this year and this sale of non-core assets is further evidence of that.” Amazing what 24 months can do, isn’t it?

Of course, Nortel isn’t alone in its horribly failed acquisition strategy. The competitive landscape is littered with acquisitions meant to “substantively enhance accretive earnings” or “create the next level of operating efficiencies,” but that rarely happens. Instead, most acquisitions turn out to be the wrong purchase for the wrong reason at the wrong time — more of an impulse buy than an accretion of value. The question is, why?

In October of 1999, Nortel was running simply to stand still in the competitive race. From Lucent to Cisco to upstarts such as Juniper Networks, the constant bombardment of competitive forces was akin to the ones that buffeted the S.S. Minnow in that fateful storm that stranded Gilligan . Not only was the competition coming from existing companies, but it also came from the almost unforeseen netherworld of venture capital start-ups. The onrush of capital into the communications equipment sector was immense.

Borrowing an approach taken by its peers — most notably Cisco — Nortel’s management decided that now was the time, amidst the rocky landscape and rough waters of 1999, to begin an acquisition spree. After all, Cisco had become a Wall Street rock star for its strategy of research and development (R&D) through mergers and acquisitions (M&A). Clarify was the beginning of that spree.

And the end? Well, by October 2, 2001, Nortel Networks was announcing that CEO John Roth would be stepping aside at the behest of the board.

Acquisitions generally happen in a furious effort to keep up with peers in the competitive landscape. Believing that they must keep pace by some metric, companies grow through combination — even, sometimes, through seemingly unholy combinations, as in the case of a communications equipment maker acquiring a customer relationship management software company. Often these “acquisitions” appear more like the mating of a car and an airplane — after all, they’re both modes of transportation, so why wouldn’t we spot-weld half a car to half an airplane?

These acquisitions are undertaken from what I would call an atomistic position. The companies are fully aware of their autonomy as companies, but they have very little sense of their interconnectedness to the larger system of their industry, or business in general. And in not having this sense, they come to believe that their action, taken in the most intensely competitive times, will become a benefit. Scientifically speaking, this is absolutely not the case.

Modern recombinatorial science — which is science-speak for sex — studies why the recombination of DNA is an effective “search strategy” in the process of evolution. Translation: Why is mating, which combines the DNA of the male and female, the most effective way for some species to evolve? The answer: Recombination is not inherently more effective or efficient than any other “search strategy.” So now the question (ignoring the obvious carnalities) becomes: Then, why sex at all? And the answer to that question is relevant to the current topic.

Recombinatorial science speaks of “fitness landscapes” much like business speaks of “competitive landscapes.” Fitness landscapes are a way of describing the variation in the evolutionary environment. In a rough fitness landscape, the peaks and valleys have massive distances between them — that is, the variations are large. In a smooth landscape, the peaks and valleys have little to no variation at all.

When search strategies, that is, ways of evolving, are layered over the different fitness landscapes, their effectiveness and efficiency become immediately apparent. A recombinatorial strategy, the evolutionary equivalent of mergers and acquisitions, works very well in a smooth fitness landscape but not in a rough one. The reason for this is that recombination is an incremental evolution. It does not, indeed cannot, lend itself to the kinds of wide-variation, gap-jumping improvements that are demanded by a rough landscape. The business equivalent: Conducting acquisitions against a “rough landscape” backdrop is evolutionary suicide. Nortel Networks never should have made that acquisition. At least, that’s what modern science would say.

The time for M&A is when the smooth landscape presents itself. How will you know when the smooth landscape has arrived? The capital flows slowly. Competition doesn’t seem as great. Survival seems paramount in importance. Companies have roughly the same metrics in Wall Street parlance. In short, an industry slowdown, or an economic recession, is a smooth fitness landscape. Nortel Networks should have been acquiring Clarify at the precise moment that it was instead selling it.

Rough landscapes call for peak jumping — that is, for innovation. Smooth landscapes call for incrementalism — that is, M&A. It’s a simple lesson that could have saved Nortel Networks $1.9 billion.

But recombinatorial science does not stop there. In fact, the conclusions above aren’t even based on the latest thought. Moving on to the next stage in recombinatorial science occurs by taking a step back — back from recombination of a car and an airplane, back to the level of all recombinations and search strategies occurring within an evolutionary environment.

This is where the atomism of 19th century science disappears. For it is at this level that science becomes acutely aware of the interconnected process that is pushing the system forward. A system’s view of the process reveals the coevolutionary quality of all systems. That is to say, this view dispels the atomistic view that an autonomous agent (a company) can undertake an action against its surrounding environment (the competition) without substantively altering the nature of the environment. Because the environment is changed, responses from others in the environment are different than they would have been.

In other words, if you acquire a company thinking it will give you certain advantages, the very act of acquiring that company will change your competition in such a way that the advantages you thought you were acquiring will not be the advantages that accrue to you.

Every action does not have an equal and opposite reaction in an open system. Rather, every action causes avalanches of interconnected responses that are neither equal nor opposite. And those responses will change the very nature of the environment in which an agent operates.

What is a poor agent (i.e., a company) to do? It must begin by understanding the underlying forces and principles that emerge as a system organizes and interacts. This understanding — one of absolute interconnectedness to other agents and systemic forces — lays the foundation for strategy and foresight. Fortunately, the exploration of those forces and principles lies ahead.