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The Importance Of Paper LBOs In Investment Banking And Private Equity

Private Equity

The paper LBO is more likely than not to be part of your interview process if you’re interviewing for a banking or private equity role. Even if your interviewer doesn’t call it that, they might start it by saying they’ll give you a quick prompt and you will have to explain your thinking out loud on how you would solve it. If they start saying something like this, they are probably giving you a paper LBO. A paper LBO is important because it helps investment professionals quickly evaluate an investment opportunity and serves as a sense check before building a more complicated model in Excel. Additionally, paper LBOs allow an interviewer to test math skills and basic financial topics in the context of making a private investment.

During a paper-LBO test, you will be asked to estimate the internal rate of return (IRR) and Money-on-Money multiple (MoM) of an investment without using Excel or a calculator. There are a few best practices to follow when completing a paper LBO that will help move you along to the next phase of the admissions process. Some key tips to follow when you do a paper LBO include:

  • Keep in mind that this is not a full out modeling test and rather a test of your mental math and logic skills. Most of the assumptions will be simplified so that the math itself isn’t overly complicated, but you’ll have to be clear in articulating how you calculate each line item


  • These tests are quick, usually just a few minutes long, so it’s important to practice a lot beforehand so you’re not slower than other interviewees


  • It’s important to keep the end goal in mind when you’re completing the paper LBO; you want to get to a reasonable level of returns, so keep in mind that if you end up with a 50% IRR or a 5.0x MoM, you probably need to recheck your work. Similarly, if you know you are targeting a 25% IRR over 5 years, you should expect a 3x MoM; if you don’t, time to recheck


  • Simplify your assumptions if the interviewer gives you the choice to do so. For example, if they don’t tell you what change in net working capital is, tell them you are assuming 0; this will make your calculations easier


  • Make a reasonable assumption for debt, as you don’t want to over lever the company to the point that the interviewer doubts your knowledge of a typical investment


When you’re actually going through the motions of a paper LBO, the interviewer is also evaluating how well you can articulate your thinking on the fly. For the entry and exit assumptions, they may provide you with a multiple on EBITDA to value the business with, but they might also ask you to come up with that yourself. If you have no idea what the multiple should be, you can try to ask questions about the business to understand if it’s a high growth business or not. Showcasing your thinking in this way goes a long way in an interview rather than picking a random number. In general, the interviewer cares less about the numbers you use and more about how you do the math at this stage of the interview process. Once you get to a full modeling test in private equity interviews, they will care about the actual multiple you use to value the business.

Once you determine the purchase price, one of the most important parts to talk out loud about is the debt and equity assumed to purchase the company. The amount of equity, or your initial investment, is an important figure because it will be used to calculate returns when you exit the investment. Your interviewer will be testing how you think about leverage to put on the company because this is a consideration for every investment that private equity professionals look at. Too much leverage can result in high interest payments and destroy cash flows that otherwise could have been used to reinvest in the business. Try to get a sense for normal leverage levels for the types of companies the firm you’re interviewing with invests in.

When you forecast revenue, EBITDA, etc. on the income statement, be sure to state what the growth rate is, and the dollar amount in each year out until your exit year. If you’re using an EBITDA margin, be sure to explain why you might keep it constant versus have it grow (either assumption can be valid depending on the type of business you are given). When you start to calculate free cash flow, walk them through each line item: net income + D&A + capital expenditures + change in net working capital. The key of this section is to show that you (i) know the basic flow of an income statement, (ii) know the formula for free cash flow, and (iii) know that cash flows are what is used to calculate returns.

Lastly, calculating returns is the bread and butter of the paper LBO. Assume that all cash flow is used to pay down debt (unless the interviewer tells you otherwise). Then you can use your exit EBITDA multiple times EBITDA in your exit year to get an enterprise value, subtract net debt, and end up with your equity value. This equity value divided by your initial equity investment is the MoM, and IRR can be calculated using the Rule of 72. The Rule of 72 states that the internal rate of return required to double an investment can be calculated by 72 / number of years you held the investment. You can also use the Rule of 114 for 3x MoM and Rule of 144 for 4x MoM. The same math applies. Make sure to memorize these tables ahead of the paper LBO test so that you don’t have to do the division on the spot and can quickly tell your interviewer what returns to expect from this investment.

Be sure to check out the paper LBO section in the Officehours content for a full example and solution!

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