If you're interested in breaking into finance, check out our Private Equity Course and Investment Banking Course, which help thousands of candidates land top jobs every year.

## Overview

The Paper LBO is one of the most common interview questions you’ll encounter during private equity recruiting. The Paper LBO has the same structural mechanics as the leveraged buyout model, which is the primary financial analysis used in private equity. The Paper LBO is a popular interview question because it is efficient to administer, allows the candidate to explain their thought process, and touches on important technical private equity concepts.

The “Paper” LBO does not use Excel and is designed to be completed with just a pen and paper. In essence, the Paper LBO simplifies the complexities of building a complex financial model without forfeiting the key principles of an LBO.

In order to conduct a Paper LBO, you will need to be aware of the following concepts:

Enterprise Value

Sources and Uses

Forecasting Financials

Building to Free Cash Flow

Rule of 72 (approximating IRR)

To fully learn all of these concepts, you might want to check out our Private Equity Recruiting Course. This course covers all of the private equity technical information you’ll need to know. The course has several Paper LBO examples and also dives into the intricacies of building an LBO model in Excel.

## Paper LBO Format

A typical Paper LBO is going to have the following “rules”:

Interviewee will only use pen and paper

Interviewee is expected to show their work

Typically given less than 10 minutes to complete

Numbers provided will be relatively simple to compute

Numbers can be liberally rounded when being computed

If you’ve done investment banking interviews, you’ll realize that this is quite similar in format to complex accretion / dilution questions. You’re essentially given a bunch of numbers and then have to quickly sort out the proper steps to get to an answer.

The typical steps to complete a Paper LBO are the same as an ordinary LBO model. These steps can be condensed into the following:

Step 1: Determine Transaction Assumptions

a. How much are we purchasing the company for?

b. How much debt and equity are being used to buy the company?

Step 2: Forecast Income Statement and Cash Flow

a. How much free cash flow is the business generating?

Step 3: Calculate Debt Paydown and Returns

a. How much debt is paid down during the forecast?

b. How much cash are we getting back on our investment?

c. What is the implied return profile of the investment?

## Example Paper LBO Prompt

Let’s go over a simple Paper LBO one might encounter in a private equity interview.

It’s common to either be orally told a bunch of facts about or simply receive a list of information like below:

Assume that we are a private equity firm purchasing "Company Alpha" at the end of 2021

Purchase multiple is 10x LTM EBITDA

$200mm of revenues in 2021, which is expected to grow at $25mm annually through the forecast

EBITDA margin of 50%, flat throughout forecast

D&A and Capex are both 10% of revenues, flat throughout forecast

No change in net working capital

Tax rate of 50%

Initial leverage of 5x LTM EBITDA – assume all debt is paid down upon exit

Interest rate of 10%

Assume exit after 3 years of projections at a 10x LTM EBITDA multiple

Question: What is the implied MoM and IRR of this investment?

From this list of information, you have enough to compute this investment’s MoM and IRR. It may also be helpful to remember that we just need two numbers to compute an investment’s MoM and IRR 1) the initial equity amount and 2) the ending equity amount.

Said differently, our Paper LBO is simply a model for us to build to these two amounts (initial and ending equity).

## Example Paper LBO Solution

### Step 1: Determine Transaction Assumptions

a. How much are we purchasing the company for?

First, we want to determine what the total cost of the business was. This amount is commonly referred to as the Purchase Price and reflects how much money was spent to acquire the business.

At its simplest, all you need to get to Purchase Price is a multiple and a metric. Here, we’re told that the purchase multiple is 10x LTM EBITDA. This means we are going to multiply the number 10 by what we calculate for LTM EBITDA.

The deal is completed at the end of 2021, so the LTM (“Last Twelve Months”) pertains to the year 2021.

To get 2021 EBITDA, we can multiply the figure of $200mm in revenue by the EBITDA margin of 50%.

LTM EBITDA = $200mm * 50% = $100mm.

Purchase Multiple * LTM EBITDA = 10x * $100mm = $1B Purchase Price

b. How much debt and equity are being used to buy the company?

A company’s purchase price is going to be simply composed of either debt or equity. We can calculate the amount of debt being used by looking at the leverage number – leverage is often reported as a multiple of EBITDA. We can then back into what is being used for the equity amount. This equity amount of $500mm represents the initial investment and how much money we as the private equity firm put into this deal.

Purchase Price = $1B.

Initial Leverage of 5x LTM EBITDA means that we had 5x LTM EBITDA of debt on the business at acquisition.

5x LTM EBITDA = 5x * $100mm EBITDA = $500mm in Debt.

Purchase Price of $1B - $500mm in Debt = $500mm of Equity.

### Step 2: Forecast Income Statement and Cash Flow

a. How much free cash flow is the business generating?

The next step is to calculate how much free cash flow is generated over the forecast period. This step represents the bulk of the calculations and mental math. Your task is to essentially build from revenue to free cash flow every single year by calculating all of the steps of an income statement and cash flow statement.

Fortunately, the numbers provided in a Paper LBO tend to be simple, which makes this tedious, but oftentimes not particularly hard.

From the prompt, we know that the forecast period is 3 years. Therefore, we have to calculate how much free cash flow is generated over these 3 years in order to calculate how much debt is paid down.

The deal closed at the end of 2021, so Year 1 = 2022

Revenue Forecast

2021 Revenue (Year 0) = $200mm

2022 Revenue (Year 1) = $225mm, + $25mm from previous year

2023 Revenue (Year 2) = $250mm, + $25mm from previous year

2024 Revenue (Year 3) = $275mm, + $25mm from previous year

EBITDA Forecast

2021 EBITDA = $100mm, 50% * Revenue

2022 EBITDA = $113mm, 50% * Revenue

2023 EBITDA = $125mm, 50% * Revenue

2024 EBITDA = $138mm, 50% * Revenue

D&A Forecast

2022 D&A = $23mm, 10% * Revenue

2023 D&A = $25mm, 10% * Revenue

2024 D&A = $28mm, 10% * Revenue

Capex Forecast

2022 D&A = $23mm, 10% * Revenue

2023 D&A = $25mm, 10% * Revenue

2024 D&A = $28mm, 10% * Revenue

The Free Cash Flow Formula is as follows:

Revenue

EBITDA (50% margin)

Less: D&A (10% of revenue)

Less: Interest (Constant 10% interest rate on $500mm of debt)

EBT

Less: Taxes (50% rate on EBT)

Earnings

Plus: D&A

Less: Capex (10% of revenue)

Less: Change in Net Working Capital ($0)

Free Cash Flow

Our goal is to essentially arrange all of these formulas so we can get to Free Cash Flow for years 2022, 2023, and 2024. This may ultimately look like the below forecast:

It is worth noting that we have made the interest calculation simpler here for the purpose of this question. We say that debt is not paid down until exit, implying that we do not have to calculate debt paydown on a yearly basis. In most Excel financial models, you will compute an annual debt paydown.

We have also made the Free Cash Flow calculation simpler. Here, net income is equivalent to Free Cash Flow. That is because D&A and Capex have the same % driver and there is no change in Net Working Capital.

### Step 3. Calculate Debt Paydown and Returns

a. How much debt is paid down during the forecast?

We can safely assume here that all free cash flow generated was used to pay down debt in this forecast. This should be your default assumption in Paper LBOs unless there is other information given.

Therefore, we can calculate how much debt is paid down by just summing up the free cash flow generated over the 3 years.

Free Cash Flow 2022 = $20mm

Free Cash Flow 2023 = $25mm

Free Cash Flow 2024 = $30mm

Cumulative Free Cash Flow = $75mm

Initial Net Debt – Cumulative Free Cash Flow = Ending Net Debt

$500mm - $75mm = $425mm in Net Debt

b. How much cash are we getting back on our investment?

We then plug this debt paydown amount into the exit assumptions of the investment.

Exit LTM EBITDA = 2024 EBITDA

Exit Multiple = 10x

Exit Enterprise Value = $138mm * 10x = $1,380mm

Exit Equity Value = Exit Enterprise Value – Ending Net Debt = $1,380mm - $425mm = ~$950mm - $1,000mm of Exit Equity Value

c. What is the implied return profile of the investment?

Finally, we will use the Rule of 72 to calculate the implied return profile.

Exit Equity Value = $950mm - $1,000mm

Initial Equity Value = $500mm

Implied MoM = Exit Equity Value / Initial Equity Value = 2x MoM

72 Doubling over 3 years = ~24% IRR using the Rule of 72

Therefore, the Paper LBO implies that an acquisition of Company Alpha would have an IRR of ~24% and an MoM of 2x over the 3-year hold period.

All of the calculations were intentionally made simple enough so that you can reasonably compute the arithmetic in your head. It would take an experienced candidate less than 5 minutes to complete this question.

## Additional Complexities

What we walked through here is one of the simpler possible iterations a Paper LBO. We have much more complex examples in our Private Equity Recruiting Course. Below are some common complexities that would make the Paper LBO harder to accomplish:

Using NTM multiples instead of LTM

Paying down the debt over time

Multiple investors in the cap table

Options in the cap table

Preferred stock or other kind of structured security (requiring the calculation of PIK interest)

One-time cash outflow (e.g., paying a dividend in the 3rd year)

## תגובות