- What is the Paper LBO?
- Paper LBO vs LBO Modeling Test
- The Paper LBO "Prompt"
- Before We Begin ... Download the Excel Template
- Step 1. Input Transaction and Operational Assumptions
- Step 2. Build “Sources & Uses” Table
- Step 3. Project Financials
- Step 4. Calculate Free Cash Flow
- Step 5. Returns Analysis
- Paper LBO vs LBO Modeling Test vs On-the-job
What is the Paper LBO?
The Paper LBO refers to a common interview exercise during the private equity recruiting process, which usually works as follows: The interviewee will usually receive 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.
In this article, we will walk you through a step-by-step basic paper LBO model that introduces some of the core concepts tested during the private equity recruiting process.
Paper LBO vs LBO Modeling Test
We have written a full tutorial on the LBO Modeling Test in a separate post. The LBO Modeling Test is an excel based exercise usually often encountered in later stages of the PE interview process.
The Paper LBO "Prompt"
Below is a standard LBO test prompt. Note that for the vast majority of paper LBO tests, you will not be given a calculator — only pen and paper will be provided. Sometimes, it may even just be a verbal discussion with the interviewer.
So, you need to practice doing mental math in your head until you are comfortable doing these short-hand calculations under pressure.
Let's get started! Below is a realistic prompt for a paper LBO:
Paper LBO Prompt
JoeCo, a coffee company, has generated $100mm in last twelve months ("LTM") Revenue and this figure is expected to grow $10mm annually.
JoeCo's LTM EBITDA was $20mm and its EBITDA margin should remain unchanged in the years ahead. Based upon management guidance, the D&A expense is expected to be 10% of Revenue, capital expenditures ("Capex") will be $5mm each year, there will be no changes in net working capital ("NWC"), and the tax rate will be 40%.
If a PE firm acquired JoeCo for 10.0x EBITDA and exited at the same multiple five years later, what is the implied IRR and cash-on-cash return? Assume that the initial leverage used to fund the purchase was 5.0x EBITDA and that the debt carries an interest rate of 5% with no required principal amortization until exit.
Before We Begin ... Download the Excel Template
Use the form below to download the Excel file to help you check your work. Remember that you will likely not receive an Excel sheet to work on during the interview so we recommend that you print out the 1st sheet and solve this problem-set using pen and paper to familiarize yourself with the actual testing conditions:
Step 1. Input Transaction and Operational Assumptions
The first step of a paper LBO 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 as shown below:
Formulas Used in Step 1
- Purchase Enterprise Value = LTM EBITDA × Entry Multiple
- EBITDA Margin % = LTM EBITDA ÷ LTM Revenue
Step 2. Build “Sources & Uses” Table
Next, we will build out the Sources & 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 5.0x 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.
Keep in the mind, the ultimate goal of an LBO model is to determine how much the firms’ equity investment has grown by, and to do so – we will need to first calculate the size of the initial equity check by the financial sponsor.
Formulas Used in Step 2
- Debt Financing = Leverage Multiple × LTM EBITDA
- Sponsor Equity = Total Uses – Debt Financing
Note: 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 in the Paper LBO, so unless you were explicitly provided with additional data in the prompt, focus exclusively on the data provided.
Step 3. Project Financials
Now that we have completed filling out the Sources & Uses section of our model, we will project the financials of JoeCo down to net income (the “bottom line”). The operational assumptions that will drive the projections have already been listed out during the first step of this tutorial.
Note: For Paper LBO purposes, it is reasonable to round your calculations to the nearest whole number for convenience
Formulas Used in Step 3
- Revenue = Prior Period Revenue + Annual Revenue Growth
- EBITDA = EBITDA Margin % × Current Period Revenue
- D&A Expense = D&A % of Revenue × Current Period Revenue
- Interest = Debt Financing Amount × Interest Rate %
Step 4. Calculate Free Cash Flow
Next, we will project JoeCo’s free cash flows throughout the expected holding period, which will be five years in this case. The FCF generation ability of an LBO target will determine the amount of debt that can be paid down during the holding period – however, there will be no principal paydown assumed for this simple exercise.
Formulas Used in Step 4
- Free Cash Flow = Net Income + D&A – Capex – Change in NWC
Step 5. Returns Analysis
In the last step, we will assess the returns of the investment based on the cash-on-cash return and the IRR. Recall that the prompt stated earlier that the PE firm exited the investment at the same multiple as entry (i.e. no "multiple expansion").
Since you will likely not have access to a calculator, calculating the IRR requires some back-of-the envelope work. Since the LBO holding period assumption is usually 5 years, you can memorize these IRRs based on common cash-on-cash-returns:
The Rule of 72 (and 115)
Forgot your IRRs? No problem – in most cases, the return should be even easier to approximate under the Rule of 72, which estimates the time that it takes to double an investment as 72 / rate of return. For example, over a 5 year horizon, the approximate IRR required to double the investment is 72/5 = ~15%.
There's also the lesser-known Rule of 115, which estimates the time it takes to triple an investment as 115 / rate of return.
If you are facing difficulty estimating the IRR, there is a high likelihood that you may have made a mistake in a previous step.
As for this example, the cash-on-cash return is around 2.5x – as calculated by dividing the exit equity value by the initial sponsor equity contribution. Using either the table above or the Rules of 72 and 115, we can approximate the IRR of this investment to be marginally in excess of ~20%.
Formulas Used in Step 5
- Exit Enterprise Value = Exit Year EBITDA × Exit Multiple
- Final Year Net Debt = Initial Debt Amount – Cumulative FCFs
- Exit Equity Value = Exit Enterprise Value – Ending Year Net Debt
- Cash-on-Cash Return = Exit Equity Value ÷ Initial Sponsor Equity
- Internal Rate of Return (IRR) = Cash-on-Cash Return ^ (1 – t) – 1
Paper LBO vs LBO Modeling Test vs On-the-job
Paper LBOs are used by private equity firms (and in some cases, headhunters) to quickly vet a potential candidate and take place at fairly early stages of the PE Interview Process (i.e. first round).
As candidates progress to subsequent rounds, private equity firms often ask interviewees to complete a far more detailed LBO Modeling Test. By contrast to the Paper LBO, the LBO Modeling Test is longer, with candidates usually given 1-3 hours or even as a take-home case study.
LBO Modeling on the job
On the job, you will build two types of LBO models most frequently:
- Mini models (i.e. "short form" LBO models): These are usually similar to the level of complexity you'll encounter in an LBO Modeling Test and are used at the pre-letter of intent (LOI) stage of a deal, when the PE firm has received a Teaser, signed an NDA and received a confidential information memorandum ("CIM") from the investment banker which contains high level financial data.
- Fully integrated LBO Model with Operating Model: At later stages of the deal process, LBO models become far more advanced and contain fully integrated financial statements, as well as a variety of accounting, tax and transaction adjustments not usually tested in the recruiting process. These are the models private equity firms hire us to train their Associates on. To learn how to build these more advanced models, enroll in Wall Street Prep's LBO Modeling course.