After investing in Activision Blizzard for the arbitrage opportunity, I have been requested to look at Zynga, which seems to be in the same situation as Activision. Zynga is a gaming stock being acquired.

The arbitrage opportunity in the deal between Microsoft and Activision is straightforward. It is an all-cash transaction where there is currently a spread of 21.6%. If you buy the shares of Activision today and the deal goes through tomorrow, you are certain to make a profit of 21.6% in cash.

With Zynga, things are a little more complicated.

First of all, it is a stock and cash transaction, which means the acquisition price is dependent on the stock price of the acquirer, Take-Two Interactive. Zynga stockholders will receive $3.50 in cash and $6.361 in shares of Take-Two common stock for each share of Zynga common stock outstanding at the closing. While in theory, it seems that you are certain to be paid $9.86 for each share of Zynga that you own, this is applicable only in a range. There is a collar mechanism on the deal.

There are three possible scenarios:

If Take-Two’s 20-day volume weighted average price (“VWAP”) ending on the third trading day prior to closing is in a range from $156.50 to $181.88, the exchange ratio would be adjusted to deliver total consideration value of $9.86 per Zynga share (including $6.36 of equity value based on that VWAP and $3.50 in cash)

If the VWAP exceeds the higher end of that range, the exchange ratio would be 0.0350 per share

if the VWAP falls below the lower end of that range, the exchange ratio would be 0.0406 per share

Before we go any further, I believe we need to define this VWAP. VWAP is calculated by totaling the dollars traded for every transaction (price multiplied by the volume) and then dividing by the total shares traded.

For simplicity, we can use the 20-Day Simple Moving Average (SMA) instead of VWAP. The two numbers are around the same if the daily average volume doesn't change much. In these volatile times, however, the error in this simplification will increase. This is something for the technical analysts to worry about. For us, fundamental analysts, this simplification is enough.

The next step is to look at a concrete example.

Let's say the VWAP is $160. It is in the first range, which means you are certain to obtain $9.86 for each share of ZNGA that you own. You will receive $3.50 in cash and 0.03975 shares of TTWO.

If the VWAP is $170, you are still in the first range, still obtaining $9.86 but your number of shares will be adjusted. You will receive only 0.3741 shares of TTWO and $3.50 in cash.

Now if the VWAP goes above this range to $200, you will receive $3.50 in cash and 0.0350 shares of TTWO for a total of $10.50.

And finally, if the VWAP is below the range, let's say at $100, you will only receive $3.50 in cash and 0.0406 shares of TTWO for a total of $7.56.

Right now, we are closer to the fourth scenario. The SMA is at $126, which means you will obtain $3.50 in cash and 0.0406 shares of TTWO for a total of $8.61. The current price of ZNGA is $7.58, giving you a spread of 13.6%.

The stock price of TTWO has been falling in recent months along with the rest of the market, therefore, the most likely scenario is that we stay in that lower range. I have given this scenario a probability of 50%. There is also a scenario where the deal doesn't go through that I have given a probability of 20%. The expected return is 12%.

Is this a good arbitrage opportunity?

That 12% is dependent on the stock price of TTWO. A month ago the VWAP was at $150 with a spread of 7%. If you had invested in ZNGA back then and the deal closed today, you would have made a loss of 4%. You may argue that the market lost over 9% in a month and you would still have beaten the market but we are still looking at the case that the deal goes through. What happens if the deal doesn't go through? You can lose 21% and you will be holding an overvalued stock. According to my analysis, Zynga is worth only $1.8 billion.

Like any merger arbitrage opportunity, there is always a risk, that's why we also call it risk arbitrage. But here the risks are leveraged because of the way that the deal is structured. The reward is not big enough to justify the risk in my opinion.

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