Understanding Paper LBOs in Private Equity Interviews

Why Paper LBOs Are Popular

• Common in analyst and associate level interviews.
• Tests key mechanics of an LBO, the primary model in private equity.
• Can be administered orally or with simple instructions.

Content Overview

• Explanation of paper LBOs.
• Mechanics involved.
• Example paper LBO question walkthrough.

Key Concepts Needed for Paper LBO

1. Enterprise Value
2. Sources and Uses
3. Forecasting Financials
4. Free Cash Flow
5. Rule of 72

Format and Rules of Paper LBO

• Entirely paper-based, no Excel needed.
• Must complete financial forecasts by hand in under 15 minutes.
• Simple numbers, rounding allowed.

Steps to Compute a Paper LBO

Step 1: Determine Transaction Assumptions

• Price negotiation: How much is the company being purchased for?
• Debt and Equity: How much of each is used?
  • Debt is analogous to a mortgage.
  • Equity represents investor contributions.

Step 2: Forecast Financials

• Focus on income statement leading to free cash flow.
• Typically simpler than a full three-statement model.
• Aim to assess free cash flow over the investment holding period.

Step 3: Calculate Debt Paydown and Returns

• Assess how much cash is generated by the asset to pay down debt.
• Calculate the cash return at investment end.
• Use the Rule of 72 to determine return profile.

Example Paper LBO Question

• Scenario: Private equity firm purchasing Company Alpha at 2021 year-end.
• Purchase multiple: 10x LTM EBITDA.
• Revenue and Profitability: $200M revenue, grows $25M annually, 50% EBITDA margins.
• Costs: D&A and CapEx each 10% of revenue, flat.
• Leverage and Exit: 5x LTM EBITDA leverage, 10% interest rate, 3-year exit.

Solution Walkthrough

1. Determine Purchase Price:

   • Calculate LTM EBITDA: $200M (Revenue) x 50% (Margin) = $100M.
   • Purchase Price: $100M x 10 = $1B.

2. Financing Structure:

   • Debt: 5x EBITDA = $500M.
   • Equity: Remaining $500M.

3. Forecasting Financials:

   • Revenue increases by $25M annually.
   • EBITDA calculated at each year with given margins.
   • Subtract D&A and interest to get to EBT, deduct taxes, and calculate net income.
   • Adjust for D&A and CapEx to find free cash flow.

4. Calculate Debt Paydown:

   • Cumulative free cash flow over 3 years = $75M.
   • Net debt at exit: $500M (Initial Debt) - $75M (Cumulative FCF) = $425M.

5. Exit Value and Return Analysis:

   • Exit Enterprise Value: 2024 EBITDA x 10 = $1.38B.
   • Equity Value at Exit: $1.38B - $425M = ~$1B.
   • Investment Return: Exit Equity / Initial Equity = 2x.
   • IRR Calculation: Rule of 72 → 72 ÷ 3 years = ~24%-25% IRR.

Conclusion

• Understanding paper LBOs is crucial for private equity and buy-side interviews.
• Offers practice in financial modeling and return analysis.
• Top performing deals often show 2x return in 3 years and IRRs above 20%.
• Practice is essential to master these concepts.