RIV Increases Distribution 50%. Is it Safe? What to Expect?
RiverNorth Opportunities Fund (NYSE:RIV) announced that it will adopt a managed distribution policy of $0.21/share beginning August 2017 (ex-date August 10). This is a 50% increase from the current $0.14/share and brings its market yield to 12.6% based on Friday's closing price ($19.97) and the NAV yield to 12.2%.
RIV is a young fund with its inception date of 23 December 2015. It is an unleveraged CEF fund of funds holding a portfolio of other closed-end funds, business development corporations, and some corporate debt. I wrote about the fund about a year ago (RiverNorth's New Fund Takes An Opportunistic Approach... and RiverNorth Opportunities CEF: A Follow-Up…) where I took note of some of its unusual and unique aspects. One in particular stands out as we try to determine the impact of the large distribution increase. Quoting from the follow-up article cited above: "After five years of the fund's existence, December 2020, shareholders will vote on the question of converting the fund from a closed-end fund to an open-end fund. The conversion will take place at NAV. This provision more or less guarantees that shareholders who stick around will not lose any value to a widening discount…. It is one of the most shareholder friendly approaches to a CEF". And, "today's discount is doubly attractive because the CEF has pretty much stacked the deck against any blowout losses to discount." At the time, the discount was -5.3%, and I suggested that it was unlikely to go much lower. At Friday's close, it was -3.43%.
RIV has taken a disruptive approach to CEFs. The policy cited above is one example. Another, also described in the follow-up article cited, was its policy of returning 50% of NAV gains for the early life of the fund when it carried the premium valuation typical of new CEFs. This new distribution policy looks to be more of this disruptive approach.
Everyone welcomes a nice increase in income from their holdings. But it is not so clear that an increase of this magnitude will truly benefit shareholders. I felt that the policies noted above were exceptionally shareholder friendly and encouraged long-term holds of the fund. The new policy may well be advantageous to shareholders who will almost certainly see short- to mid-term gains. But as I'll describe, I'm less inclined to see it as providing long-term value from the fund.
The first question that an RIV investor must ask is: How sustainable will that distribution be? I tried to get a handle on this by looking at what the RIV portfolio components are paying. Unfortunately, the published portfolio is six months old. In addition, several of the component funds have undergone changes, including mergers since that time, so it's impossible to get a clear picture of the present situation. But by simply using the top holdings in that portfolio, which accounted for more than 50% of the fund's portfolio, I come up with a weighted average market yield of 9.12%. Obviously, that is not the current number, but I find it very difficult to imagine changes that could have brought that weighted average to anything close to 12.6%. In fact, in browsing the full portfolio from six months ago, I suspect the calculation based on only this 52% of the portfolio overestimates the income received by the fund.
RIV has included return of capital in its monthly $0.14 regular distribution only four times, three of these in the first three months, so it looks to have been earning its distribution. According to the Section 19a notices, capital gains account for a significant fraction of RIV's distributions: 65% so far in 2017 and 30% in 2016 which is consistent with my inferences on the fund's investment income.
The fund describes its investment strategy as being "designed to capitalize on the inefficiencies in the closed-end fund space while simultaneously providing diversified exposure to several asset classes." Capitalizing on the inefficiencies in closed-end funds implies frequent trading of holdings with the goal of capturing gains from exploiting said inefficiencies. I consider this an excellent approach to investing in closed-end funds and is one of the reasons I liked this fund a year ago reasoning that RiverNorth's experienced managers could do a better job than I navigating the quirks inherent in closed-end fund investing.
My take is that RIV intends to pay that increased distribution from capital gains. So, Question Two: Will it be able to do that?
Note that over the last year, RIV's total return is 20%, an impressive showing vs. SPY's 17.5%, so it has been performing well and rewarding its investors. But NAV has only increased 1.12%, which tells us that the fund's distribution has little room to accommodate additional growth, let alone growth of 50%, without taking a toll on the fund's net asset value.
This says to me that we will begin seeing more return of capital from RIV as it tries to meet that 12.2% NAV yield and that the return of capital will have to come at the expense of NAV growth. Furthermore, if NAV does decline as a consequence of the high payout, maintaining the $0.21/share managed distribution will mean NAV yield will have to increase taking a further toll. I may be underestimating RIV's potential for increasing its capital gains from "exploiting the inefficiencies in the closed-end fund space." But the modest cushion provided by that small NAV increase (indeed, for much of the year NAV return had been negative) does not suggest that is likely.
What is likely, however, is that RIV's discount will be reduced even further.
One of the "inefficiencies" of the CEF space is in how investors respond to yield. Increases in NAV yield go hand in hand with increases in discount and premium levels. Regular readers will be familiar with the plot I frequently use showing Discount/Premium vs. NAV yield and will recall that strong positive correlations for those metrics are near universal among funds within CEF categories. So, that 50% yield increase is almost certain to be accompanied by discount loss from the current -3.43%.
Which raises Question Three: How much can we expect the discount/premium to change?
When I first wrote about RIV, I felt that one of its appeals was that it afforded protection against losses to a deepening discount. This derives from its intention to allow shareholders to move the fund from a closed-end fund to an open-end fund thereby moving its value fully to NAV. Had the fund developed a deep discount, a positive vote would be a foregone conclusion. But discount losses, particularly if the valuation status moves into premium territory, will work against any inclination by shareholders to move the fund to an open-end structure. I see no indication that RIV might revisit the vote to convert to open-end fund should the December 2020 vote fail, which it will surely do if the fund carries a meaningful premium at that time. The prospectus tells us "If not approved by shareholders, the Fund will continue in operation as a closed-end management investment company." I suggest this is precisely where the fund is heading, and there is no more than a vanishingly small probability that the fund will revert to open-end status in 2021. But between now and then, the investor will certainly not have to worry about losing to a growing discount whatever the market may do, so the initial appeal of not losing on discount still holds.
I fully expect the discount to disappear as investors flock to the high yield the fund is offering. Consider that at a 10% premium, the present 12.2% NAV yield would still be 11.1% at market, and at a 20% premium, it would be 10.2%. These are attractive yields. To the extent that attractive yields drive premium valuations, double-digit premiums would not be out of line with what we see in other CEFs. There are, according to CEF Analyzer, 11 funds with NAV yields greater than 12%. The median premium for those 11 is 6.51%. If NAV yield alone were the only driver of premiums, one could project it going as high as 20%. But it's not, although correlations in the 50% range are not uncommon.
Question Number Four: What does this all mean to RIV's investors?
My view is that the new managed distribution is not sustainable, will likely come at the expense of NAV decay, and will drive the discount into premium territory by the usual forces that operate in the CEF marketplace.
Assuming I'm correct in how I see the new RIV distribution policy playing out, we have an interesting situation. On one hand, it seems unwise to hold a fund that looks to have set itself up for NAV decay over and above any normal market moves in asset values. But on the other, a CEF investor is always looking for opportunities for gains from premium/discount moves, and RIV may well be gaining substantially on that front. I might consider a buy of RIV, but I would do so with the intention of collecting that nice distribution yield until selling as it moves up into premium territory. The trick will be to get out before the wheels come off.
Do you own RIV? Are you considering owning RIV? I'd be interested in hearing your point of view on this move by RiverNorth. Please join the discussion with your opinions.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in RIV over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not an investment professional and this article does not constitute investment advice. I am passing along the results of my research on the subject. Any investor who finds these results intriguing will certainly want to do all due diligence to determine if any security mentioned here is suitable for his or her portfolio.