What Is Original Issue Discount? How Credit Funds Recognize OID on Direct Loans

When a direct lender funds a loan at less than its face value, say advancing $97M on a $100M commitment, the $3M difference represents original issue discount, or OID. This discount effectively increases the lender's yield above the stated coupon rate, but the accounting treatment requires careful attention to recognition timing.

A Simple Example

A fund originates a $10 million term loan at "98", meaning it advances $9.8 million to the borrower but is owed $10 million at maturity. The $200,000 difference is OID. The loan pays SOFR + 500 bps in cash interest, but the lender's true yield is higher because they also earn that $200,000 discount over the loan's life. The question is whether to recognize that $200,000 gradually over four years (amortization) or all at once on day one (immediate recognition).

How Does OID Arise in Direct Lending?

OID emerges whenever the issue price of a loan falls below its stated principal amount. In private credit, this typically happens for a few reasons:

• The lender negotiates a discount as additional yield compensation for credit risk

• Upfront fees are structured as a reduction to the funded amount rather than a separate cash payment

• Market conditions require pricing below par to complete the transaction

The discount represents additional return to the lender, but unlike cash interest, that return is not received until the loan matures or prepays. The accounting question is how to recognize this income over the loan's life.

What Are the Recognition Options?

Practice varies across the industry, though a clear majority follows a consistent approach. Based on surveys of BDCs and credit funds, approximately 67-69% treat OID as incremental yield and amortize it over the loan term using the effective interest method. A smaller percentage, around 15% of BDCs, book the discount entirely as immediate fee income at origination.

The distinction matters for several reasons:

• Amortization approach: The discount is added to yield and recognized gradually, increasing the loan's book value each period until it reaches par at maturity

• Immediate recognition approach: The full discount is recorded as income at closing, with the loan carried at par from day one

Some managers split the treatment, allocating a portion of the OID to fees (recognized immediately) and the remainder to yield (amortized over time). The allocation often depends on how the discount was negotiated, whether it was primarily a yield enhancer or compensation for structuring and origination work.

How Does Amortization Work Mechanically?

For funds that amortize OID, the effective interest method calculates a constant yield on the loan's carrying value over its expected life. Each period:

• Interest income is calculated using the effective rate (which incorporates the OID) applied to the current book value

• The difference between this amount and cash interest received increases the loan's carrying value

• The book value gradually rises toward par as the discount amortizes

Simplified example: Take the $10 million loan funded at $9.8 million with a four-year term. If the stated coupon is 10% ($1 million cash per year), the effective yield incorporating the OID is approximately 10.6%. In Year 1, the fund recognizes roughly $1.04 million in interest income, $1 million received in cash plus about $43,000 of OID amortization. The loan's book value rises from $9.8 million to roughly $9.84 million. By Year 4, the book value reaches $10 million and all OID has been recognized.

Most managers amortize to contractual maturity, though some use shorter periods when active secondary markets suggest the loan may trade near par well before maturity.

What Happens on Prepayment or Sale?

If a borrower prepays before the OID fully amortizes, the remaining unamortized discount is typically accelerated into income at that point. The same logic applies if the fund sells the position, any remaining discount embedded in the book value would be realized as part of the sale proceeds.

Example: Using the same loan, suppose the borrower refinances after two years when roughly $90,000 of OID has been amortized and $110,000 remains. The fund receives the $10 million payoff but only has a $9.89 million book value. That $110,000 difference accelerates into income immediately, creating a spike in that quarter's earnings.

This acceleration can create income timing that differs from expectations, particularly in portfolios with significant prepayment activity. Controllers often track unamortized OID balances separately to forecast the impact of early payoffs on quarterly earnings.

How Does Fair Value Election Change the Treatment?

Funds that elect fair value accounting under ASC 825 generally recognize upfront fees and costs, including OID, immediately rather than deferring them. This creates a meaningful difference in income timing and can affect comparability when evaluating performance across managers using different accounting elections.

For funds reporting at amortized cost, consistent application of the chosen OID policy, and clear disclosure to investors, helps maintain credibility and avoids quarter-to-quarter volatility from policy changes.