What is original issue discount (OID) on a loan?

How OID works

Every term loan has a face amount: the principal the borrower owes, pays interest on, and repays. With OID, the lender funds less than that. A term sheet may say the loan is issued at 98, meaning 98 for every 100 of face, or that there is an OID of 2 points. Either way, on a loan with a face of 10,000 the borrower receives 9,800 and owes 10,000.

Economically, OID is an upfront fee paid to the lender. It is simply collected by holding back part of the loan instead of by an invoice at closing. Lenders favor it for a few reasons. It raises their return without raising the coupon, which keeps the stated rate competitive and the cash interest that coverage ratios are measured on a little lower. It is the way fees are conventionally expressed in private credit and syndicated loans, where a loan's price in the market is quoted per 100 of face.

OID appears most often in private credit pricing, unitranche and second-lien loans. Banks more commonly charge an origination fee instead, and SBA loans have their own fee structure, led by SBA's guaranty fee.

OID is a fee that looks like a price. Treat 98 as 2 points of fee on the whole face amount, and compare it that way.

What OID does to the all-in yield

The discount is paid once, at the start, but it buys the loan for as long as it stays out. So its cost per year depends on how long that is. A simple approximation divides the discount by the expected life of the loan and adds it to the coupon. The lender's pricing usually assumes a life of a few years, because many private credit loans are refinanced or repaid before maturity.

Two things follow. First, OID is cheapest for a borrower who keeps the loan to maturity and most expensive for one who repays early. An owner who expects to sell or refinance in two years should read 2 points of OID as roughly one point a year, not a small one-time charge. Second, OID and call protection compound: an early exit pays the prepayment premium on top of an upfront fee that never had time to spread out.

The right comparison between offers is the all-in cost over the years the borrower actually expects to hold the loan: coupon, discount and fees together, on one timeline. Interest rate versus all-in cost sets that out, and SOFR plus a spread covers the floating part of the coupon.

What OID does to the cash at closing

Because the lender funds less than face, the business receives less cash than the loan amount on the term sheet. In an acquisition, that gap has to be covered in the sources and uses: either the loan is sized up so that its net proceeds meet the need, or the buyer brings more equity. A buyer who plans a purchase around the face amount and forgets the discount arrives at closing short.

Sizing up to cover the discount has a cost of its own. The borrower then owes interest and principal on the larger face amount, and leverage covenants are measured on face, not on cash received. On a loan sized close to a lender's leverage limit, a discount can be the difference between fitting under a total leverage cap and not. Transparent's financing model carries face and net proceeds separately, so the sources and uses, the covenants and the cost of the loan are all computed on the right number.

OID versus a closing fee: tax and accounting

Economically, 2 points of OID and a closing fee of the same amount paid to the lender cost the borrower the same. Where they differ is in mechanics, and in some cases in how they are recorded. The details below are general; the borrower's accountant should confirm treatment on any specific loan.

Under US GAAP, the result is that neither OID nor a lender fee is expensed at closing. Both reduce the recorded amount of the loan and are recognized as interest expense over its life, using the effective interest method. On the income statement, interest expense therefore runs a little higher than the cash coupon each year. For a lender reviewing the financial statements, that difference is a non-cash item, and in a covenant definition the amortization of OID and fees is often excluded from the interest used in coverage ratios. Worth checking in the agreement rather than assuming.

For US federal tax, OID is generally deductible as interest as it accrues over the loan's term on a constant-yield basis, whether or not any cash changes hands for it. Amounts the borrower pays the lender at closing are generally treated the same way, by reducing the loan's issue price and so increasing the OID. Very small discounts relative to the loan's term can fall under a de minimis rule. Costs paid to third parties are debt issuance costs, amortized over the term under their own rules. When a loan is repaid early, the unamortized balance is generally deducted at that point.

Negotiating OID

• Trade it against the spread. Lenders will often move points between OID and the coupon. A borrower who expects to hold the loan long should accept more OID for a lower spread; one who expects to repay early should do the reverse.
• Know how delayed draws are priced. On a delayed draw term loan, OID may be charged on each draw when it funds, at the original or a new price.
• Check amendment and repricing fees. Some agreements charge a further discount or fee on later amendments or add-on loans.
• Size the loan on net proceeds. Decide at the term sheet stage whether the loan will be grossed up to cover the discount, and what that does to leverage.
• Compare offers on the same life. Put every offer's coupon, OID and fees on the expected hold period before choosing.

Transparent puts competing offers side by side on those terms, drawn from the 1,148 lenders in its book that write term and private credit, so the discount is weighed against the spread, the call protection and the covenants rather than read on its own.