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Paper LBO Model Example: How to rip through a paper

LBO in 5 minutes
Andrew C.
Alrighty campers. Today, I’m gonna teach you all about paper LBOs.

I’ll show you how to develop a gut instinct for whether a PE deal is attractive or not.

If you follow along and practice a few times on your own afterward, you’ll soon develop an instinct
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Why is this important? Break Into Private Equity:
Because you WILL be asked to do this on the fly in interviews by just about all PE firms. Networking, Interviewing,
And LBOs
So developing this instinct and judgment on your own and searing it into your brain is critical.
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What is a paper LBO?

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A paper LBO is exactly what it sounds like: modeling an LBO and calculating returns using only a
paper and pencil.
Let's Do This
You might be allowed to use a calculator, but you might not. So it’s best to assume you’ll have
to do all the math in your head.

Given that, I have 2 guidelines:

One, SIMPLIFY your assumptions as much as possible. But be transparent and call out
when you simplify something. You can say it’s something you would go into more detail if you
had more time (or a computer). Products
3 Statement, DCF, and LBO
Two, use round numbers to make estimates easier to compute in your head. If you are Modeling Online Training Videos:
dealing with decimals, round them. Say you’re doing this to simplify calculations and it Combo Packages
shouldn’t change the answer about whether to invest. Again, you can say you’d go into more
Financial Modeling Online Video
detail if you had more time, or a computer.
Training Course: 3 Statement and
DCF Modeling
It’s definitely OK to use round numbers and simplify assumptions. In fact, it’s highly
recommended. PE and LBO Modeling Training
Videos
That is MUCH better than trying to be a superhero and calculate to the 2nd decimal place on
Private Equity Interview Guide:
everything and then making MISTAKES.
How to Nail Your Private Equity
Mistakes in a paper LBO easily snowball and blow up your calculations. Interview (whether you have
finance training or not)
You can end up with results that make no sense. And that’ll just make you look stupid. Those
situations don’t result in offers. How to Break into Private Equity:
Forward
Don’t do that…

Keep things simple. Focus only on the key stats you need.

The key stats you need to calculate returns / deal attractiveness are:

The entry multiple Popular posts

The exit multiple
What the multiple is keyed off of (typically EBITDA, but you should confirm) What Do Private Equity Investors
Revenue, if EBITDA is not given to you directly Actually Do?
EBITDA margin, if the amount is not given to you directly Types of Private Equity Funds
Depreciation & Amortization amounts or %
Top Private Equity Firms in New
CapEx amounts or %
York City
Starting debt amount
Interest % How Private Equity Firms Really
Terms of any mandatory debt repayment schedule (e.g., linear repayment, bullet payment) Make Money: The Carried Interest
Estimated change in net working capital (if not given, you’ll have to deduce the difference Distribution Waterfall
between non-cash current assets and non-debt current liabilities, then compute the change
Paper LBO Model Example: How to
in net working capital for each period)
rip through a paper LBO in 5
Cash taxes
minutes

Why Can You Make So Much Money

Focus like a laser beam on extracting these stats from the problem and you’ll be well-positioned
In Private Equity?
to evaluate the deal efficiently.
Private Equity LBO Modeling Tests:
Let’s jump into our example to show you what we mean.
Who gets them? What are they?
Let’s say PE Capital Partners is evaluating whether to invest in TargetCo, a regional brick and Private Equity LBO Modeling Tests:
mortar retail chain with 50 stores across 8 states. Key Components of the LBO
Modeling Test Presentation
The company sells general purpose merchandise just like Wal-Mart does, but it’s less than 10
years old and appeals to younger shoppers who want a cleaner shopping experience. Who are the top headhunters for
private equity jobs?
PE Capital is considering a purchase for 5.0x LTM EBITDA. LTM Revenue is $500M. PE Capital will
borrow 60% of the purchase price and invest 40% equity capital. The weighted average interest How Are Private Equity Firms
rate for all debt is estimated at 8%. Structured?

So Who Gets Private Equity Jobs

The credit agreement provides that $30M must be amortized annually. PE Capital plans to use all
Anyway?
excess free cash to pay down principal.
Private Equity LBO Modeling Tests:
TargetCo’s revenue is expected to grow organically 7% annually for the next 5 years, at which
The Interview Presentation, How to
time PE Capital plans to sell the company. The company’s biggest revenue drivers are electronics
Practice, and How the Test is
and household products.
Evaluated
Over the last few years, TargetCo has fairly consistently booked EBITDA margins of ~20%. Capital How Do You Get a Private Equity
expenditure hovers around 5% of revenue annually. Net working capital is roughly 3% of revenue Job? (Series)
per year. The company depreciates ~80% of its CapEx each year. The company’s tax rate is 40%.
How Does the Recruiting Process
Whew! I just threw a lot of facts at you. for Private Equity Jobs Work?

In your PE interview, your paper LBO case might be simpler, or it might be more complicated. It Private Equity and LBO Modeling
might have lots of extraneous information. It might be a 3-page print out with 80% irrelevant Training Course
details. What Is Private Equity?

The point is, it can take lots of different forms. So whatever it is, you’re gonna have to quickly What are pre-MBA private equity
organize the facts and pull out the critical pieces of info you need. associate interviews like?

To use your time efficiently, I strongly urge you to work backward

backward. Start with the END What are Bain Capital pre-MBA
RESULT you want, and then back into the data you need to compute that result. private equity associate interviews
like?
In this case, it’s easy to determine the ENTRY purchase price.
When Should You Start Looking for
But to evaluate the EXIT price and equity return, you’ll have to know what final year EBITDA is, a Private Equity Job?
and how much debt is left at the end of the holding period. Why did you leave the private
After you know that, the equity return is easily calculated as: equity profession?

(Total exit price – remaining debt) / Original entry equity

That is the formula for determining your multiple-of-money return.

Burn that formula into your BRAIN

BRAIN, because you are going to ruthlessly solve for each piece of
that formula.

The most computationally intensive piece is by far the remaining debt amount after 5 years.
That will always be the variable that takes the most arithmetic to solve.

You can solve for the other pieces fairly easily.

To solve for the entry purchase price, you just need the purchase multiple and the starting EBITDA
amount.

To solve for exit price, you need the purchase multiple and the ending EBITDA amount.

So let’s start with those.

For the entry price, we take LTM revenue of $500M, compute LTM EBITDA of 20% which is
$100M, and multiply by the entry multiple of 5.0x.

That’s a $500M purchase price.

Since we know the debt vs. equity split is 60 / 40, we determine right away that the transaction is
$300M debt, $200M equity.

So our original entry equity is $200M.

For the exit price, absent other information, you should always assume you’ll use the same
multiple you purchased at at, in this case 5.0x LTM EBITDA.

Why?

Because, even if we did nothing during the time we own the company, as long as we paid a FAIR
price for it, we should be able to assume the next buyer will also pay a fair price for it — as
reflected in the purchase multiple.

Of course, that assumes we did not overvalue the company in the first place!

And assuming we as PE investors actually IMPROVE the company, say, by growing revenue above
organic rates or by optimizing costs, then we may arguably get an even HIGHER purchase multiple
at exit because we’ve actually done the hard work of improving the company.

For now, let’s calculate the exit price by taking Year 5 EBITDA and simply multiplying it by our
original 5.0x multiple.

It’s gonna take a bit of math, so let’s work quickly through it.

Revenue grows at 7% annually and EBITDA is 20%.

So, starting with $500M LTM revenue, quickly calculate Year 5 revenue. (Remember: no
calculators.)

I like to use this little shortcut:

First, I know 10% of $500M is $50M, so half that is $25M, which is 5%.

Second, I know 1% of $500M is $5M, and double that is $10M, which is 2%.

5% + 2% = 7% (annual revenue growth). So that means $25M + $10M + $500M is Year 1 revenue
growth.

Scribble that onto your paper, like this:

At end of year…

Y0 Y1 Y2 Y3 Y4 Y5

500 535 ? ? ? ?

Now I do the same shortcut for Year 2.

10% of $535M is $53.5M. Half that is $26.75, which a double decimal, which makes my head want
to explode.

So I’m gonna round up to $54M and take half that instead, which is $27M. That’s close to 5%.

Good enough for government work, as they say.

When I do this, I’ll probably orally call out my rounding move to be transparent about why I’m
making this simplification (i.e., it’s good enough for an estimate, it’ll yield the same answer, and
it’s faster to compute).

1% of $535M is $5.35M. Double that is $10.7M. Decimals make my head want to explode. So I’m
gonna simplify and round up to $11M, which is my 2% estimate.

Now I’ll just add $27M + $11M + $535M:

Y0 Y1 Y2 Y3 Y4 Y5

500 535 573 ? ? ?

Keep going.

10% of $573M is $57.3M. Half that is $28.65M. My head wants to explode. Round up to $29M for
5%.

1% of $573M is $5.73M, double that is ~$11.4M. My head wants to explode. Simplify and round
down to $11M for 2%.

Add it up: $29M + $11M + $573M.

Y0 Y1 Y2 Y3 Y4 Y5

500 535 573 613 ? ?

Keep ripping through.

10% of $613M = $61.3M, half that rounded down is $30M.

1% of $613M = $6.13M, double that is $12.26. Explode. Round down to $12M.

$30M + $12M + $613M:

Y0 Y1 Y2 Y3 Y4 Y5

500 535 573 613 655 ?

Last lap.

10% of $655M = $65.5M, half that rounded up is $33M.

1% of $655M = $6.55M, double that is ~$13M.

$33M + $13M + $655M:

Y0 Y1 Y2 Y3 Y4 Y5

500 535 573 613 655 701

Voila.

Now you have revenue estimates for 5 years. It’s not decimal accurate, but it’s good enough for a
paper LBO for sure.

Don’t get complicated and try to do decimals unless you are a FREAK OF NATURE whiz at doing
quick math.

Be open and transparent about your rounding moves and your interviewer will be fine with it.

In fact, some people only round to units of 10 or 5, like this:

Y0 Y1 Y2 Y3 Y4 Y5

500 535 570 610 655 700

That will create slightly larger computation errors, but is largely still correct.

The fact that we’re at least calculating to the single integer level means our analysis is already
pretty sophisticated.

Anyway, final year LTM revenue of $701M means final year LTM EBITDA at 20% margin is
~$140M (rounding for simplicity).

$140M at a 5.0x multiple is $700M.

So ~$700M is our exit price

price.

Now, remember the key stats we said you should focus like a laser beam on earlier?

You can now cross some items off that list.

The entry multiple

The exit multiple
What the multiple is keyed off of (typically EBITDA, but you should confirm)
Revenue, if EBITDA is not given to you directly
EBITDA margin, if the amount is not given to you directly
Depreciation & Amortization amounts or %
CapEx amounts or %
Starting debt amount
Interest %
Terms of any mandatory debt repayment schedule (e.g., linear repayment, bullet payment)
Estimated change in net working capital (if not given, you’ll have to deduce the difference
between non-cash current assets and non-debt current liabilities — which is net working
capital; then figure the change in NWC for each period)
Cash taxes

We’ve used all those pieces to calculate our exit price.

Now we just need to know how much debt is left at the end of Year 5 to calculate our multiple-of-
money return.

We’re gonna need our EBITDA numbers for all the interim years to compute our debt paydown, so
let’s fill those in now (rounding where appropriate).

EBITDA is 20% per year, so:

Y0 Y1 Y2 Y3 Y4 Y5

Revenue 500 535 573 613 655 701

EBITDA 100 107 115 123 131 140

With our EBITDA numbers in place, we now have to compute annual free cash flow to determine
how much debt to pay down each year.

Free cash flow is:

EBITDA
Less: CapEx
Less: Interest expense
Less: Cash taxes
Less: Change in net working capital

To compute interest expense, you’ll need to know how much debt is paid off each year. ‘Cause the
way we’re going to compute interest is as a simple percent of beginning of year debt (to keep
things simple).

To compute cash taxes using the 40% tax rate, we first need to know the interest expense amount
and the depreciation / amortization amount, since both are tax-deductible.

Finally, computing CapEx and net working capital is straightforward. We know CapEx is 5% of
revenue and NWC is 3%. We also know depreciation is 80% of CapEx.

So let’s just estimate these statistics and fill them into our paper chart quickly, using round
numbers, no decimals:

Y0 Y1 Y2 Y3 Y4 Y5

Revenue 500 535 573 613 655 701

EBITDA 100 107 115 123 131 140

Depreciation 20 21 23 25 26 28

CapEx 25 27 29 31 33 35

NWC 15 16 17 18 20 21

Now let’s compute interest expense, which is 8% of beginning of year debt. We’ll have to compute
this simultaneously with calculating each year’s debt paydown.

That’s because the amount of debt we amortize each year determines next year’s beginning of
year debt balance.

In turn, that determines the year’s interest expense, cash taxes, and free cash available for debt
repayment. There is a corkscrew-like circularity in the formula, which you should Google if you’re
not familiar with it.

So we have:

Y0 Y1 Y2 Y3 Y4 Y5

Revenue 500 535 573 613 655 701

EBITDA 100 107 115 123 131 140

Depreciation 20 21 23 25 26 28

Interest – ? ? ? ? ?

Cash taxes 32 ? ? ? ? ?

CapEx 25 27 29 31 33 35

NWC 15 16 17 18 20 21

Beg. debt – 300 ? ? ? ?

Cash taxes are computed as:

(EBITDA – Depreciation – Interest expense) * 40%

For Year 0 (LTM), cash taxes are: (100 – 20 – 0) * 40% = $32M.

We won’t compute free cash for Year 0 because we don’t know what the change in NWC was from
the prior year. But it doesn’t matter ‘cause we only need to start our analysis from Year 1.

So in Year 1, let’s now compute interest expense, cash taxes, and free cash flow.

Interest expense is 8% of $300M, or $24M.

So pre-tax earnings are: (107 – 21 – 24) = $62M.

Cash taxes are 40%, or $24.8M, but let’s round up to $25M for simplicity.

Now we can compute free cash flow for Year 1. It’s:

EBITDA 107
Less: CapEx 27
Less: Interest payments 24
Less: Cash taxes 25
Less: Change in NWC 1

$31M in free cash. Let’s fill that in:

Y0 Y1 Y2 Y3 Y4 Y5

Revenue 500 535 573 613 655 701

EBITDA 100 107 115 123 131 140

Depreciation 20 21 23 25 26 28

Interest – 24 ? ? ? ?

Cash taxes 32 25 ? ? ? ?

CapEx 25 27 29 31 33 35

NWC 15 16 17 18 20 21

Beg. debt – 300 ? ? ? ?

FCF – 31 ? ? ? ?

End debt 300 269 ? ? ? ?

As you can see, we also went ahead and reconciled beginning to ending debt amounts.

We know we have to pay back $30M off the debt note each year, and we use all excess cash to pay
down additional principal.

In this case, we’ll amortize $31M off the note in Year 1, leaving a balance of $269M at the end of
Year 1.

Let’s crank through Year 2:

Y0 Y1 Y2 Y3 Y4 Y5

Revenue 500 535 573 613 655 701

EBITDA 100 107 115 123 131 140

Depreciation 20 21 23 25 26 28

Interest – 24 22 ? ? ?

Cash taxes 32 25 28 ? ? ?

CapEx 25 27 29 31 33 35

NWC 15 16 17 18 20 21

Beg. debt – 300 269 ? ? ?

FCF – 31 35 ? ? ?

End debt 300 269 234 ? ? ?

We first calculate interest as 8% of $269M, or ~$22M.

Then we compute cash taxes: (115 – 23 – 22) * 40% = $28M.

Then we compute free cash flow:

EBITDA 115
Less: CapEx 29
Less: Interest payments 22
Less: Cash taxes 28
Less: Change in NWC 1

We get: $35M.

Backing that out from our debt balance leaves $234M in debt left.

As you can see, there’s a fair amount of arithmetic to solve the debt paydown amount for each
year.

Being able to work quickly, accurately, and efficiently with pencil on paper, and without
having to rely on a calculator, is a very critical skill.

Repeating the computation process for each remaining year, and rounding to whole numbers
where appropriate, leaves us at the end of Year 5 with:

Y0 Y1 Y2 Y3 Y4 Y5

Revenue 500 535 573 613 655 701

EBITDA 100 107 115 123 131 140

Depreciation 20 21 23 25 26 28

Interest – 24 22 19 16 12

Cash taxes 32 25 28 32 36 40

CapEx 25 27 29 31 33 35

NWC 15 16 17 18 20 21

Beg. debt – 300 269 234 194 148

FCF – 31 35 40 46 52

End debt 300 269 234 194 148 96

Final year ending debt is $96M.

So now we can finish our formula:

(Total exit price – remaining debt) / Original entry equity

Our entry was $500M, $300M debt and $200M equity.

Our exit is $700M

$700M.

Remaining debt is $96M.

The multiple-of-money is:

(700 – 96) / 200 = ~3.0x.

So, in 5 years, we triple our money by investing in TargetoCo with 60% debt and just riding the
company’s organic momentum. (Remember: we haven’t suggested anything to improve the
company and accelerate sales or cut costs yet.)

We have a good idea of the IRR as well, which will be ~25% annually.

I know that because I’ve already memorized that, over a 5-year hold, the following multiples of
money translate approximately into the following IRRs:

2.0x MoM → ~15% IRR

2.5x MoM → ~20% IRR

3.0x MoM → ~25% IRR

3.7x MoM → ~30% IRR

You should do the math yourself to validate these numbers, and then once you do, burn them
into your BRAIN so you don’t have to think about them anymore when you’re doing your
analysis.

Now, this paper LBO also shows you exactly how much of the value is created from the company’s
operations vs. from juicing returns using leverage / debt.

If we used zero debt in the transaction, we would have spent $500M in equity capital upfront, and
received ~$700M at exit, for a net return of $200M which is a 40% return over 5 years, or an IRR
of ~7% annually.

With debt financing, our IRR is ~25%, and we take home a net return of ~$400M after 5 years.

So leverage can create value.

But generally speaking, if that’s the ONLY card to play in a deal, the deal may not be worth doing.
(In real life, it’ll be haaaaard to book a 25% IRR using leverage alone.)

There might be other places to deploy capital that will yield a higher risk-adjusted return —
especially considering that private equity is pretty much illiquid until the fund retires.

Based on personal experience, a 3.0x MoM (~25% IRR) over 5 years is generally the target you
have to try and hit for a PE deal to be attractive.

And to hit a 3.0x return, you’re usually gonna have to truly create some value by rolling up your
sleeves and getting involved operationally.

You’ll have to grow EBITDA. In fact, one heuristic I’ve internalized is that you should basically
shoot to roughly double EBITDA over 5 years to achieve a worthwhile return.

Double EBITDA.

Now, how can you do that?

Well, there’s really only 2 ways: increase sales, or decrease costs.

You can:

Grow revenue by volume (desirable)

Grow revenue by price (not desirable, because not sustainable)
Reduce costs without adversely impacting revenue (by trimming fat / operating costs,
optimizing supplier relationships / reducing COGS, managing working capital more
efficiently)

Whether through one of these methods or a combination of them, the truly value-added PE
investors, the top-quartile ones, will proactively grow EBITDA beyond organic levels.

In doing so, they generate a higher return and IRR for their LPs than mediocre PE investors.

You want to be able to vocalize THESE kind of insights when you tear down paper LBOs in your
interview.

It shows your interviewer you not only have a strong grasp of the financial analytics. But you also
see the big picture of where private equity returns come from: how much from organic lift, how
much from leverage, how much from operational improvements, how much from multiple
expansion, etc.

Demonstrating mastery of these concepts, along with the financial details, is what will set you
apart and get you to the next round.

So, study what I’ve shown you in this lesson and do a bunch more practice problems to get
REALLY FAMILIAR with it.

It is a learnable skill.

If you put in the time and thought and diligence, you WILL be able to crank through paper LBOs
like this in about 5 minutes, and then sit up and carry an insightful and thoughtful discussion
about the company / deal for another 15.
 That’s what it means to crush a paper LBO.

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