Why is OID considered a use of cash (LBO)?

energeticowl's picture
Rank: Chimp | 10

Hey guys,

Been thinking about this problem for the past few hours. From a balance sheet perspective, I can see why an OID would be categorized the same as something like a financing fee, where it is netted against the debt financed and amortized over the term. However, there seems to be a conceptual difference between the two. A financing fee actually lowers the amount of debt raised- If you wanted to raise 100MM of cash, but there was a 10MM financing fee, you would need to raise 110MM of debt. On the other hand, if there was a OID of 20%, you would only need to "use" $80MM to get $100MM of cash.

By treating OID as a use of cash, you are basically forcing yourself to take on more debt in the sources section even though you are actually receiving a price discount. How does this make sense? Any help in reasoning this through with me is much appreciated.

Regards,

a curious analyst.

Comments (8)

Sep 1, 2017

The best reasoning I've thought of so far: If you can "use cash" to fund a min. cash balance, then you can "use cash" to fund an OID, since it's essentially cash from the price discount..

Sep 3, 2017

OID is a "use" of cash, because it's cash you can't use for one of the other uses, e.g., purchase equity.

In sources, you put the face value of debt; in uses only the received cash can be used to actually do things, so the OID must be included as a bridge.

Ex:

Sources:
* Debt $100mm
* Equity $25mm

Total Sources: $125mm

Uses:
* Purchase Equity $100mm
* Refi Debt $10mm
* Transaction Expenses $5
* OID / Financing Expenses: $10mm

Total Uses: $125mm

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Jul 29, 2018

So to make sure I get this straight, the whole point of an OID is to buy debt for cheaper than face value.

When you're modeling an OID, it's amortized over the life of the debt and capitalized on the balance sheet (under other noncurrent assets, just like financing fees?)

Edit - I guess you don't capitalize it on the balance sheet because it goes on the debt schedule.

One point of confusion - in the WSO practice full LBO #1, the OID is repaid over time (I think - it's amortized over time), like a term loan would be. I'm looking at the Investopedia article on OID and it said the OID is paid back at the time of maturity. Can someone explain?

Thank you very much.

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Jul 31, 2018

When you say "buy" debt, it can be a little confusing since it's unclear who is "buying" - you mean the creditor funding the loan, vs. the debtor taking the loan and its proceeds.

From a creditor perspective, OID is another way to increase returns without charging the company a higher interest rate. If my fund has a hurdle rate, OID may be the final plug in the excel model that gets me over my IRR hurdle; while staying within the given rates the debtor company wishes to lend at. There may also be timing constraints where a highly levered company is uncomfortable with higher interest rates (read: the true price of their credit risk), but is willing to make it up in the form of an OID.

OIDs can be stepped in a variety of ways - as a bullet at maturity, amortized over the life of the loan, etc. - the exact amortization rate, OID rate, and other specifics will be laid out in the term sheet.

    • 5
Jul 31, 2018

Oh I see. That makes sense. And now I know how not to phrase it re: "buy" debt. Thank you for the answer here, SB'd.

A few follow up questions.

1) How would you decide how to step OIDs without context? I am just thinking to best practice if there's no specification on a "term sheet" if I'm trying to model out an interview model, which is my most pressing present hurdle.

2) Why would OID get you over your IRR hurdle? I don't quite conceptually understand that mechanic. If you could explain that or point me in the direction of something to read up on then that would be super helpful.

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Most Helpful
Jul 31, 2018

So conceptually; OID is just a discount to the creditor on the face value of the bond. For instance; on a bond with 2% OID and $100 par value, I put in $98 to buy the bond, and at maturity will receive $100.

1) Really depends on the underlying cash flows of the company. Generally, OID will not make a huge impact on flows unless it is very big - looking on Bloomberg now, I only see 42 loans with priced below 90 cents on the dollar. For the sake of an interview model, I would straight-line it at issue until maturity or bullet it at maturity.

2) Thinking about the $100 example above, that's an extra $2 in my pocket I don't have to pay at the start. So if you're thinking about IRR as a series of cash flows (a negative cash flow for investment(s), then positive cash flows for interest and principal repayments), OID reduces my initial negative cash flow while keeping the interest and principal payments the same. Thus, my IRR increases.

    • 6
Sep 19, 2018

Helpful. Thanks. SB'd.

Sep 21, 2018
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