Written by a Top OfficeHours Buyside Coach
Have you memorized the core IRR/MoM combinations for your case study yet?
Are you preparing for upcoming private equity interviews?
If so, understanding the mechanics of a leveraged buyout is paramount…
Paper LBOs are an important part of any private equity interview. If you aren’t familiar with the term, a paper LBO is a way for an interviewer to test your knowledge of the basic mechanics of an LBO (leveraged buyout) without using a computer or Excel. This test will usually be part of your first few interviews at a private equity shop since it is used to screen out candidates before the more intensive modeling test that is commonly administered at many firms or before meeting more senior professionals.
It is important to nail the paper LBO portion of your interview to show your interviewer that you understand the methodology behind how an LBO works and can perform quick math either with pen and paper or with mental math. It’s relatively easy to master if you practice beforehand, as the test has a structure that many investment professionals will expect you to follow.
Step 1: Review Prompt and Assumptions
During the interview, you may be given the prompt in a variety of ways. You may be given a piece of paper with assumptions written out, the interviewer may verbally tell you all the necessary assumptions to perform the LBO, or you might be prompted to ask questions to determine what relevant information you need. The last of those ways is the most challenging since you won’t be given the information outright… By practicing with written down prompts, you can get a sense of what types of financial figures and assumptions you will need to make to properly complete the paper LBO.
Step 2: Calculate the Purchase Price of the Company
First, you will want to calculate the purchase price of the company. Usually, you will be given (or you will have asked for) two figures to do this for a private company:
Year 1 EBITDA and an entry EBITDA multiple.
Calculating the purchase price entails simply multiplying Year 1 EBITDA * entry EBITDA multiple.
If you are working with a public company (i.e. this buyout will be a private takeover), you may instead be given (or have asked for) the share price and number of shares outstanding.
This becomes a bit more complicated since multiplying the share price by the number of shares outstanding will yield equity value but not enterprise value (which is what the purchase price will be).
To go from equity value to enterprise value, add the net debt (debt minus cash) of the company to equity value.
There are a few other elements you can also add, such as preferred stock or noncontrolling interest, to get from equity value to enterprise value. These items are less common, but you can ask your interviewer if you should include them if they are not given in the prompt.
Even if they are not, it can show your interviewer you are aware these can be included in the enterprise value calculation.
Step 3: Calculate Debt and Equity Funding Amounts (Sources & Uses)
Since LBOs are financed using a combination of debt and equity, you’ll need to determine how much of each will be used in the transaction. You will be given (or will ask for) some ratio to get to that determination. For example, if you are told that the transaction will be financed with 40% debt, multiply 40% by the purchase price to determine the amount of debt you will need to use. The remaining portion (60% * purchase price) will be financed with equity.
You can create a basic source & use a table with this information. On the uses side, it will just be the purchase price for the company. On the source side, you will have two lines: debt and equity.
Typically, if you do an LBO in Excel, the equity amount becomes a “plug” that is solved for by subtracting debt from the purchase price.
In a paper LBO, we don’t have other complicated costs like financing fees, deal fees, rollovers, etc., so it is easier to make a simple source & uses tables for your reference throughout the test.
Step 4: Build the Income Statement
You will likely have some pen and paper for this part since it’s harder to keep the numbers in your head to project the income statement. Start by writing out the following lines of the income statement: on
 Revenue
 EBITDA
 Less: Depreciation and Amortization (D&A)
 EBIT
 Less: Interest Expense
 EBT / NOPAT
 Less: Taxes
 Net income
The “less” indicates a subtraction to get the following line (ex. EBITDA – D&A = EBIT) and is a common way of showing the income statement in financial statements/modeling tests.
You may be given an assumption for how long the asset’s hold period will be. If not, ask the interviewer if you can assume 5 years or if they’d rather you use a different time period. You will also need growth assumptions for each of these lines (again, these will be laid out or you should ask for them), including:
 Revenue: annual growth rate
 EBITDA: EBITDA margin and any margin expansion/contraction expected
 D&A: set a figure or % of another metric
 Interest expense: interest rate, which you will multiply by the debt amount used for the purchase to find the annual interest expense
 Taxes: tax rate, which you will multiply by EBT to find annual taxes paid
Project out the entire income statement for the required number of years plus one more (you will need this additional year to calculate returns in the last step).
Step 5: Calculate Free Cash Flow
The last step before calculating returns is calculating free cash flow (FCF). The equation for FCF is:
FCF = Net income + D&A (noncash expense) – capital expenditures – change in net working capital
You will need to calculate FCF every year in the hold period (but not for the extra year, or year 6). The cumulative FCF over the hold period will be used to pay down debt (which will come into play when calculating returns next).
Step 6: Calculate Returns
First, calculate your enterprise value, or the value of the company, at exit.
Take your forward EBITDA (so EBITDA in year 6, or use year 5 EBITDA if it is specified to do that instead) * exit EBITDA multiple to get enterprise value at exit.
Ask for exit multiple assumptions if they are not given; as a rule of thumb, we generally assume the same multiple at entry and exit.
Then, calculate your net debt at exit. This is done by subtracting beginning debt (so 40% * original purchase price) – debt pay down (which is the sum of cash flows from years 1 – 5 since we are assuming all cash goes to pay down debt).
Next, calculate the ending equity value by subtracting the ending enterprise value – net debt at exit.
From there, you can calculate your multiple on money (MoM) by dividing the ending enterprise value / beginning enterprise value (purchase price).
You can estimate IRR based on an MoM table since you won’t have access to an IRR function in Excel or a calculator.
Memorize these few IRR / MoM combinations so you can approximate them at the end of the modeling test (and if your MoM falls between one of these, you can estimate based on the ends of the range).
2x MoM over 5 years > ~15% IRR
2.5x MoM over 5 years > ~20% IRR
3.0x MoM over 5 years > ~25% IRR
3.7x MoM over 5 years > ~30% IRR
Finally, you’re done! Make sure you have walked your interviewer through your thought process out loud as you are working. If you catch a mistake midway through or later on, going back to fix it is better than getting through the whole thing and having the interviewer correct you. At the end of the test, don’t worry if you have estimates for some of the numbers since sometimes mental math can be difficult during the test, and interviewers care less about that and more about the methodology.
“REMEMBER, interviewers value the way you approach problems and your ability to think critically.”
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