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 **within 5 minutes** of looking at a deal / company.

Why is this important?

Because you WILL be asked to do this on the fly in interviews by just about all PE firms.

So developing this instinct and judgment on your own and searing it into your brain is critical.

**What is a paper LBO? **

A paper LBO is exactly what it sounds like: modeling an LBO and calculating returns using only a paper and pencil.

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).

- Two,
**use round numbers**to make estimates easier to compute in your head. If you are dealing with decimals, round them. Say you’re doing this to simplify calculations and it shouldn’t change the answer about whether to invest. Again, you can say you’d go into more detail if you had more time, or a computer.

It’s definitely OK to use round numbers and simplify assumptions. In fact, it’s highly recommended.

That is MUCH better than trying to be a superhero and calculate to the 2nd decimal place on everything and then making MISTAKES.

Mistakes in a paper LBO easily snowball and blow up your calculations.

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.

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
- 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, then compute the change in net working capital for each period)
- Cash taxes

Focus like a laser beam on extracting these stats from the problem and you’ll be well-positioned to evaluate the deal efficiently.

Let’s jump into our example to show you what we mean.

Let’s say PE Capital Partners is evaluating whether to invest in TargetCo, a regional brick and mortar retail chain with 50 stores across 8 states.

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.

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 rate for all debt is estimated at 8%.

The credit agreement provides that $30M must be amortized annually. PE Capital plans to use all excess free cash to pay down principal.

TargetCo’s revenue is expected to grow organically 7% annually for the next 5 years, at which time PE Capital plans to sell the company. The company’s biggest revenue drivers are electronics and household products.

Over the last few years, TargetCo has fairly consistently booked EBITDA margins of ~20%. Capital expenditure hovers around 5% of revenue annually. Net working capital is roughly 3% of revenue per year. The company depreciates ~80% of its CapEx each year. The company’s tax rate is 40%.

Whew! I just threw a lot of facts at you.

In your PE interview, your paper LBO case might be simpler, or it might be more complicated. It might have lots of extraneous information. It might be a 3-page print out with 80% irrelevant details.

The point is, it can take lots of different forms. So whatever it is, you’re gonna have to quickly organize the facts and pull out the critical pieces of info you need.

To use your time efficiently, **I strongly urge you to work backward**. Start with the END RESULT you want, and then back into the data you need to compute that result.

In this case, it’s easy to determine the ENTRY purchase price.

But to evaluate the EXIT price and equity return, you’ll have to know what final year EBITDA is, and how much debt is left at the end of the holding period.

After you know that, the equity return is easily calculated as:

**(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**, 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**, 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 + $568M.

Y0 | Y1 | Y2 | Y3 | Y4 | Y5 |

500 | 535 | 573 | 608 | ? | ? |

Keep ripping through.

10% of $608M = $60.8M, half that is $30.4M. Head explodes. Round down to $30M.

1% of $608M = $6.08M, double that is $12.16. Explode. Round down to $12M.

$30M + $12M + $608M:

Y0 | Y1 | Y2 | Y3 | Y4 | Y5 |

500 | 535 | 573 | 608 | 650 | ? |

Last lap.

10% of $650M = $65M, half that is $32.5M. Round up to $33M.

1% of $650M = $6.5M, double that is $13M.

$33M + $13M + $650M:

Y0 | Y1 | Y2 | Y3 | Y4 | Y5 |

500 | 535 | 573 | 608 | 650 | 696 |

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 | 650 | 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 $696M 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**.

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 | 608 | 650 | 696 |

EBITDA | 100 | 107 | 115 | 122 | 130 | 139 |

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 | 608 | 650 | 696 |

EBITDA | 100 | 107 | 115 | 122 | 130 | 139 |

Depreciation | 20 | 22 | 23 | 24 | 26 | 28 |

CapEx | 25 | 27 | 29 | 30 | 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 | 608 | 650 | 696 |

EBITDA | 100 | 107 | 115 | 122 | 130 | 139 |

Depreciation | 20 | 22 | 23 | 24 | 26 | 28 |

Interest | – | ? | ? | ? | ? | ? |

Cash taxes | 32 | ? | ? | ? | ? | ? |

CapEx | 25 | 27 | 29 | 30 | 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 – 22 – 24) = $61M.

Cash taxes are 40%, or $24.4M, but let’s round down to $24M 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 24
Less: Change in NWC 1**

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

Y0 | Y1 | Y2 | Y3 | Y4 | Y5 | |

Revenue | 500 | 535 | 573 | 608 | 650 | 696 |

EBITDA | 100 | 107 | 115 | 122 | 130 | 139 |

Depreciation | 20 | 22 | 23 | 24 | 26 | 28 |

Interest | – | 24 | ? | ? | ? | ? |

Cash taxes | 32 | 24 | ? | ? | ? | ? |

CapEx | 25 | 27 | 29 | 30 | 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 | 608 | 650 | 696 |

EBITDA | 100 | 107 | 115 | 122 | 130 | 139 |

Depreciation | 20 | 22 | 23 | 24 | 26 | 28 |

Interest | – | 24 | 22 | ? | ? | ? |

Cash taxes | 32 | 24 | 28 | ? | ? | ? |

CapEx | 25 | 27 | 29 | 30 | 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 | 608 | 650 | 696 |

EBITDA | 100 | 107 | 115 | 122 | 130 | 139 |

Depreciation | 20 | 22 | 23 | 24 | 26 | 28 |

Interest | – | 24 | 22 | 19 | 16 | 12 |

Cash taxes | 32 | 24 | 28 | 32 | 35 | 40 |

CapEx | 25 | 27 | 29 | 30 | 33 | 35 |

NWC | 15 | 16 | 17 | 18 | 20 | 21 |

Beg. debt | – | 300 | 269 | 234 | 194 | 150 |

FCF | – | 31 | 35 | 40 | 44 | 51 |

End debt | 300 | 269 | 234 | 194 | 150 | 99 |

Final year ending debt is **$99M.**

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**.

Remaining debt is **$99M. **

The multiple-of-money is:

(700 – 99) / 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. **