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.
Table of Contents
- Paper LBO Practice Step-by-Step Tutorial
- How to Complete the Paper LBO
- Paper LBO Illustrative Prompt Example
- Paper LBO Test – Excel Model 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: LBO Returns Analysis
- Paper LBOs in Private Equity Interviews
Paper LBO Practice Step-by-Step Tutorial
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, you will NOT be given a calculator — only pen and paper will be provided. In fact, it could 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.
How to Complete the Paper LBO
Before we begin, the steps to build a paper LBO are outlined below.
- Step 1 → Input Transaction and Operational Assumptions
- Step 2 → Build “Sources & Uses” Table
- Step 3 → Project Financials
- Step 4 → Calculate Free Cash Flow (FCF)
- Step 5 → LBO Returns Analysis
Paper LBO Illustrative Prompt Example
To get started, an example “prompt” for our modeling test tutorial can be found below.
- Paper LBO Prompt (PDF): WSP Paper LBO Interview Prompt
Interview Prompt Example
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 effective 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 internal rate of return (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.
Paper LBO Test – Excel Model Template
Use the form below to download the Excel file to help you check your work.
However, 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 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.
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.
Formulas Used in Step 2
- Debt Financing = Leverage Multiple × LTM EBITDA
- Sponsor Equity = Total Uses – Debt Financing
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.
Step 3: Project Financials
We have completed filling out the Sources & Uses section of our model, so now we will project the financials of JoeCo down to net income (the “bottom line”).
The operational assumptions that will drive the projections were provided in the first step.
As a side note, for interview 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 (FCFs) throughout the five-year holding period.
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.
Formulas Used in Step 4
- Free Cash Flow = Net Income + D&A – Capex – Change in NWC
Step 5: LBO Returns Analysis
Recall from 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 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.
Using either the table above or the Rule 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 LBOs in Private Equity Interviews
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, or perhaps even as a take-home case study.