Original Issue Discount (OID)
Definition
Original Issue Discount is the difference between a loan's face value and its issuance price. A $100M loan issued at 98.0 (98% of par) has $2M OID. The borrower receives $98M but owes $100M, creating additional yield for lenders beyond stated interest rate. OID is standard in private credit (2-4% typical) and serves multiple purposes: compensates lenders for upfront work and commitment, provides cushion against early refinancing, and increases all-in yield without raising stated coupon rates.
Why it matters
OID meaningfully impacts true borrowing costs and lender returns. A loan priced at L+500 with 3% OID and 5-year maturity yields L+560 all-in (60 bps from OID amortization). For borrowers, OID represents upfront dilution—they receive only 97% of proceeds but service debt on 100% of par. For lenders, OID provides downside protection: if borrower refinances early, lenders receive prepayment at par (100) on a 97-98 cost basis, locking in immediate gains. During 2020-2021, many unitranche loans had 3-5% OID; when borrowers refinanced 12-18 months later (rates compressed), lenders realized 15-20% IRRs from OID alone.
Common misconceptions
- •OID is not a 'fee'—it's principal discount that accretes over loan life. Treated as additional interest income for tax purposes.
- •Borrowers don't pay OID separately. They simply receive less than par at closing, then repay full par at maturity or refinancing.
- •OID compounds when PIK'd. If loan has OID and PIK interest, the OID accretion also compounds, creating exponential debt growth.
Technical details
Accounting and tax treatment
Lender accounting: Loan initially recorded at proceeds advanced ($98M). OID accretes monthly into interest income using effective interest method. By maturity, carrying value equals par ($100M).
Borrower accounting: Debt recorded at par ($100M), with $2M discount contra-liability. Discount amortizes into interest expense over loan life using effective interest rate.
Tax treatment: OID treated as original issue discount under IRC §1273, creating taxable interest income to lenders and deductible interest to borrowers, even though no cash changes hands. Creates timing mismatches where lenders pay tax on OID accretion before receiving cash.
Yield mathematics and IRR impact
Example: $100M loan at L+500 (assume 5% LIBOR = 10% all-in), 5-year maturity, 3% OID (issued at 97). Lender funds $97M, receives $100M at maturity plus $10M annual interest.
Simple yield calculation: Annual interest $10M + OID accretion $600K = $10.6M annual cash flows on $97M investment = 10.93% yield vs 10.00% without OID.
IRR with early prepayment: If prepaid after 2 years, lender receives $100M principal + 2 years interest. Invested $97M, returned $100M + $20M interest after 2 years = 14.5% IRR. Earlier prepayment magnifies OID benefit.
Call protection interaction: OID + prepayment penalties create powerful refinancing disincentives. If loan has 3% OID + 2% prepayment penalty, early refinancing costs borrower 5 points.
Market standards and negotiation
Historical OID ranges: 2005-2007 LBO boom: 0.5-1% OID. 2008-2010 distressed: 5-10% OID common. 2015-2019 competitive market: 1-2% OID. 2020-2021 private credit expansion: 2-4% OID. 2023-2024 normalized: 2-3% OID.
Size and structure correlation: Smaller deals ($25-100M) typically have higher OID (3-5%) to compensate for diligence costs. Larger deals ($500M+) have lower OID (1-2%) due to economies of scale.
Negotiating dynamics: Borrowers resist high OID as it reduces proceeds and creates refinancing costs. Lenders defend OID as compensation for commitment and early repayment risk. Often compromised with OID step-downs (3% year 1-2, 2% year 3, 1% thereafter).
Strategic considerations
Lender perspective: OID front-loads returns and protects against early refinancing in declining rate environments. Particularly valuable in competitive markets where borrowers refinance aggressively.
Borrower perspective: High OID reduces proceeds needed for transaction (need to borrow more) and creates drag on cash-on-cash returns. PE sponsors often negotiate caps on total upfront costs (OID + fees <5%).
Fund-level implications: OID creates mark-to-market impacts for lender funds. New loan at 97 OID immediately marks to par (100) if market pricing is at par, creating instant 3 points of unrealized gain. However, this paper gain reverses if borrower defaults.