If you’re recruiting for the pre-MBA private equity associate role, you will probably be asked to complete a paper LBO in the interview process. Along with buyside technicals, case studies, and occasionally mini-cases, paper LBO is an essential element of the interview process. This is an industry standard and it’s usually asked early in the process to weed out candidates.
What Is Paper LBO?
Essentially, the interviewers give you a hypothetical investment scenario with some rough numbers. You do the LBO math on a piece of paper with a pen and ask for whatever information you need to figure out the IRR along the way. No calculators allowed! You have to do all the calcs manually but worry not, we’ll show you how to nail it.
Note: In most exercises, the interviewers are just interested in whether you can do the LBO math and arrive at the right returns profile. One exception to this is Centerbridge – if you’re interviewing with them, you should also provide your thoughts on the business, valuation as well as the transaction structure – their paper LBO is more like a mini case study.
How Important Is It?
This is a check-the-box question. It’s used to weed out weak candidates from the get-go. Successfully completing it will allow you to continue in the process, but it won’t land you the offer. You must differentiate yourself in other areas, like showing that you can think like an investor or talking intelligently about your deals.
How to Crush It
By the time you finish reading this article and completing the exercise, you will have a structured approach towards handling paper LBOs. Once you get that down, there’s nothing more to fear.
So let’s get down right to it. Suppose the following scenario:
You are now a PE Associate and you have to figure out the expected returns on an investment. The company has revenue of $100 in Year 0, growing $10 every year. It has an EBITDA of $50 in Year 0, also growing at $10 every year. We’re buying it at the end of Year 0 for 10x LTM EBITDA with 5x leverage. Assuming we exit in Year 5 with no multiple expansion, what’s the IRR?
Tip: Take notes when the interviewer is going over the exercise. You don’t want to be the candidate that asks the interviewer to repeat the prompt multiple times. On that note, bring a pen!
Our first step is to derive the Sources & Uses. At this point, some candidates tend to ask for things like existing capital structure, minimum cash and fees. You shouldn’t. As a general interview principle, try to keep things simple. The idea is to get the IRR in the simplest form. In most paper LBO scenarios, you should just assume that there’re no fees, no min cash requirement and that you’re acquiring the company on a cash-free, debt-free basis. So the enterprise value is the equity purchase price. Just say your assumptions out loud (that you’re assuming cash-free, debt-free, no fees), so your interviewer can follow your thought process. The S&U should look like this:
Our second step is to project out the future Levered Free Cash Flows. We recommend that you go from EBITDA to Net Income, and from Net Income to EBITDA. So the math will look like this:
Tip: We strongly recommend that you walk from Net Income to LFCF as opposed to going directly from EBITDA to LFCF bypassing Net Income as some Analysts do in banking. The reasons is 2 folds. First, because it’s more complex and you risk messing up the calculations. Second, your interviewers have a fixed “right” answer & approach in mind. What we’ve found through actual in-field experience is that when we try to walk from EBITDA directly to LFCF, we often get interrupted by the interviewers asking “Are you forgetting something?” So they’ll get the impression that you’re missing calcs / got the answer wrong, even if you’ll eventually get to all the cash flow items. So do yourself a favor and bridge to Net Income first and go from Net Income to LFCF.
Tip: Ask for information as you go rather than trying to figure out every item you need upfront. This will help the interviewer follow your work and save you trouble. So now you should ask for all the missing items like D&A, interest rate, taxes, CapEx and changes in working capital.
Suppose the company has $10 of D&A, $10 of CapEx, and $5 of changes in NWC, staying constant through our investment period. Interest rate is 10% and tax rate is 40%.
Usually, your interviewer will tell you to just assume debt repayment at the end, so no complex debt schedules. Our free cash flow build should look like this:
TIP: Present expenses in negative format (either with a negative sign or put them in parentheses). We see a lot of candidates mess up an otherwise great paper LBO because they confused the signs.
Our third step is to calculate MOIC and estimate our IRR. Because we don’t have any complex debt schedule, our exit equity value is just enterprise value less transaction debt plus cash, which is the 5-year cumulative LFCF (since we bought the company on a cash-free basis with no minimum cash and all debt is repaid at the end). The key thing you should memorize here is what the estimated IRR is for different cash multiples. The reason is that you can easily calculate the MOIC on paper, but it’s difficult to calculate the IRR without a calculator. The trick is to use the MOIC as a proxy for IRR. Most paper LBOs are of 5-year period, so you can use the table below to approximate the IRR.
So there you have it! You’ve done a paper LBO and if you practice a few problem sets, you’ll get the handle of it. Below are some practice problem sets for the curious minds.
Paper LBO Problem Sets
Problem Set 1 (Standard): The company has a Year 0 revenue of $500, growing at a rate of 10% every year. EBITDA margin is 20% in Year 0 and remains constant throughout the holding period. We’re buying it at the end of Year 0 at 10x LTM EBITDA multiple. We’re financing it with 4x of bank debt @ 5% and an additional 2x of bond @ 10%. Assume $20 of D&A in Year 0, growing by $5 every year. CapEx = D&A. Fixed working capital changes of $10 every year. 40% tax rate. Exit at the end of Year 5 with the same multiple as at entry.
Problem Set 2 (Advanced): The company is a retailer with 20 stores and has a Year 0 revenue of $5,000. Every year, the retailer opens 5 new stores. Opening each new store will require $20 in growth capital expenditures but will add $150 in sales in the first year of operation. Each new stores built after Year 0 grow revenue by $10 every year after the first year. The existing 20 stores’ cumulative revenue grows by a total of $250 every year. All new and existing stores has an EBITDA margin of 20% and need maintenance capex of $3 / store every year. Each store has a D&A of $5.
For maintenance capex and D&A calculations, include impact of new stores from the same year in the count. Changes in working capital is a flat $110 every year. We’re buying the business at the end of Year 0 at 10x LTM EBITDA and financing it with 4x of bank debt @ 5% interest and an additional 2x of bond @ 10%. Assume 40% tax rate. Exit at the end of Year 5 with the same multiple as at entry.
Commentary: Problem Set 2 is a challenging one and mirrors 2 paper LBOs we saw given out at 2 large PE firms. One was on a private school business and another on a healthcare center business that they own. It’s tricky in that you need to give thoughts to exactly how the financials are driven by the business model. But once you figure it out, it’s very straightforward.
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