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Paper LBO

Guide to Understanding the Paper LBO

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Paper LBO

Paper LBO: Practice Tutorial Guide (Step-by-Step)

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 shorthand calculations under pressure.

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 Example: Illustrative Prompt

To get started, an example “prompt” for our modeling test tutorial can be found below.

Illustrative 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.

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Paper LBO Model Test – Excel Template

Use the form below to download the Excel file to help you check your work.

However, remember that in all likelihood, you will not receive an Excel sheet to work on during the interview.

Therefore, we recommend printing out the 1st sheet to solve this problem set using pen and paper to familiarize yourself with the actual testing conditions.

Submitting ...

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:

Step 1. Input Transaction and Operational Assumptions

Purchase Enterprise Value = LTM EBITDA × Entry Multiple
EBITDA Margin (%) = LTM EBITDA ÷ LTM Revenue

Step 2. Build Sources and Uses Table

Next, 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 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.
Step 2. Build “Sources & Uses” Table

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 and 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.

Step 3. Project Financials (Income Statement)

As a side note, for interview purposes, it is reasonable to round your calculations to the nearest whole number for convenience.

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 (FCF)

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.

Step 4. Calculate Free Cash Flow (FCF) for Debt Repayment

Free Cash Flow = Net Income + D&ACapexChange in NWC

Step 5. LBO Returns Analysis (IRR and MOIC)

In the last step, we will assess the returns of the investment based on the cash-on-cash return and the internal rate of return (IRR).

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): IRR and MOIC Approximations Chart

The Rule of 72 (and 115)

Forgot your IRR approximations? 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 divided 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 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 Rule of 72 and 115, we can approximate the IRR of this investment to be marginally in excess of ~20%.

Step 5. LBO Returns Analysis (IRR and MOIC)

Exit Enterprise Value = Exit Year EBITDA × Exit Multiple
Final Year Net Debt = Initial Debt AmountCumulative FCFs
Exit Equity Value = Exit Enterprise ValueEnding 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

Private Equity Recruiting: Paper LBO and LBO Modeling Tests

The paper LBO test is used by most private equity firms – and in some cases, even 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.

Master LBO Modeling Our Advanced LBO Modeling course will teach you how to build a comprehensive LBO model and give you the confidence to ace the finance interview.
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February 9, 2022 3:40 pm

Wouldn’t you acquire the company on an NTM EBITDA number?

Last edited 1 year ago by Arthur Dussias
Janice Poelen
Janice Poelen
July 5, 2022 1:01 pm

I think this is very misleading: “ In this particular example, the purchase multiple used was 10.0x EBITDA and the deal was funded using 5.0x leverage.” You would expect that Debt to EBITDA (i.e. the definition of leverage) is 5x such that the transaction is funded by 5/6*200=183.33 million Debt… Read more »

June 4, 2022 10:53 am

I just completed this paper LBO – Thank you. In how long should this paper LBO need to have been completed?

Allison Clark
Allison Clark
March 16, 2023 12:47 pm

Does this get you to levered or unlevered FCF?


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