What is the Paper LBO?
The Paper LBO is a common exercise completed during the private equity interview process, for which we’ll provide an example step-by-step practice test along with a walkthrough of each of the core concepts.
The Paper LBO: Practice Tutorial Guide
Starting off, the interviewee typically receives a “prompt” – a short description containing a situational overview and certain financial data for a hypothetical company contemplating an LBO.
The interviewee will be given a pen and paper and 5–10 minutes to arrive at the implied IRR and other key metrics based exclusively on the information provided in the prompt.
For practically all private equity interviews, do not expect the interviewer to hand you a calculator, because only a pen and paper will be provided.
In fact, the entire paper LBO test could even just be a verbal discussion with the interviewer.
Therefore, make sure to practice completing mental math in your head until you are comfortable performing shorthand calculations under timed pressure.
The paper LBO test is used by most private equity firms – or in some cases, headhunters – to quickly vet a potential candidate and take place at fairly early stages of the PE interview process, i.e. the first round.
As candidates progress to subsequent rounds, private equity firms often ask interviewees to complete a far more detailed LBO modeling test, or perhaps even a take-home case study.
How to Complete the Paper LBO?
Before we begin, the steps to complete a paper LBO test are outlined below.
- Step 1 → Input Transaction and Operating Assumptions
- Step 2 → Build Sources and Uses of Funds Table
- Step 3 → Project Financials
- Step 4 → Calculate Free Cash Flow (FCF)
- Step 5 → LBO Returns Analysis
Illustrative Paper LBO Prompt
To get started, the following is an example prompt for our practice paper LBO test.
Paper LBO Prompt Example
JoeCo, a coffee company, has generated $100mm in last twelve months (LTM) revenue and this figure is expected to increase by a growth rate of 10% annually into the foreseeable future.
JoeCo’s LTM EBITDA was $50mm and its EBITDA margin should remain unchanged in the years ahead.
Based upon management guidance, JoeCo’s depreciation and amortization (D&A) and its capital expenditures (Capex) is expected to be 5.0% as a percentage of revenue, with no change in net working capital (NWC) and the effective tax rate fixed at 25%.
For the financing of the LBO, assume the initial leverage ratio used to fund the purchase was 6.0x EBITDA and that the debt carries an interest rate of 8.0% with no required principal amortization until maturity, at which debt is fully paid down upon exit.
Paper LBO Example
Fill out the following form to access the paper LBO template, which we recommend using to confirm your calculations are correct.
However, it is rather unlikely that you’ll receive a laptop with Excel in the interview setting, nor a calculator.
Therefore, we print out the 1st sheet to solve this problem set and complete the exercise using pen and paper to practice under the actual testing conditions.
1. Input Transaction and Operating Assumptions
The first step is to lay out the operational assumptions that were provided in the prompt and to calculate the total amount paid to purchase the target company.
2. Build Sources and Uses of Funds Table
In the next step, we will build out the Sources and Uses table, which will be a direct function of the transaction structure assumptions. In this particular example, the purchase multiple used was 10.0x EBITDA and the deal was funded using 6.0x leverage.
More specifically, the objective of this section is to figure out the exact cost of purchasing the company, and the amount of debt and equity financing that would be required to complete the acquisition.
The amount of debt used will be calculated as a multiple of LTM EBITDA, while the amount of equity contributed by the private equity investor will be the remaining amount required to “plug” the gap and make both sides of the table balance.
Ultimately, the main goal of an LBO model is to determine how much the firm’s equity investment has grown, and to do so – we need to first calculate the size of the initial equity check by the financial sponsor.
In a real LBO model, the Uses of Funds Section will likely include transaction and financing fees, among other uses. In addition, other more complex concepts like management rollover will be reflected in both the sources and uses of funds.
However, these nuances are unlikely to show up here, so unless you were explicitly provided with additional data in the prompt, focus exclusively on the data provided.
3. Financial Forecast
The operational assumptions that will drive the projections were provided in the first step.
Note: In the context of a private equity interview, it is reasonable to round your calculations to the nearest whole number for convenience, i.e. round the figures to the nearest 5 or 10 to simplify the math.
4. Calculate Free Cash Flow (FCF)
With our financial forecast complete, we can now calculate JoeCo’s free cash flows (FCFs) throughout the five-year holding period.
The FCF generation of an LBO target determines the amount of debt that can be paid down during the holding period. However, our prompt mentioned assume no principal paydown.
5. LBO Exit Valuation and Return Metrics (IRR and MOIC)
Earlier, the prompt stated that the PE firm exited the investment at the same multiple as the entry multiple (i.e. no “multiple expansion”).
Since you will likely not have access to a calculator, calculating the IRR requires some “back-of-the-envelope” math.
The standard investment holding period assumption is 5 years, so we recommend memorizing the IRRs based on the most common MOIC returns.
The Rule of 72 in Paper LBOs
Forgot your IRR approximations? No problem – in most cases, the return should be easy to approximate under the Rule of 72, which estimates the time that it takes to double an investment.
The approximate number of years necessary for the investment value to double in size can be determined by dividing 72 by the rate of return.
For example, over a 5-year horizon, the approximate IRR required to double the investment is ~15%.
- Number of Years to Double = 72 ÷ 5 = ~15%
There’s also the lesser-known Rule of 115, which estimates the time it takes to triple an investment. Here, the formula takes 115 and divides it by the rate of return.
If you are facing difficulty estimating the internal rate of return (IRR), it is very likely that a mistake was made in one of the prior steps.
The implied MOIC in our hypothetical LBO scenario comes out to around 3.2x, which we calculated by dividing the exit equity value by the initial sponsor equity contribution.
Using either the table above or the Rule of 72 and 115, we can estimate the internal rate of return (IRR) on our hypothetical LBO investment to be approximately ~26%.
- Multiple on Invested Capital (MOIC) = 3.2x
- Internal Rate of Return (IRR) = 26.0%