Paper LBO

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21 Aug, 2024

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A Paper LBO, also called a Pen and Paper LBO, usually prepared by candidates during private equity interviews, is a miniature paper version of a full Leveraged Buyout (LBO) Model. Interviewers use it to judge a candidate’s analytical skills and finance knowledge.

The basic paper LBO has a structure and mechanism similar to a full-fledged LBO. However, it does not involve computerized calculations. Instead, candidates must build the paper LBO model relying only on mental calculations—they use their mental abilities and create models with pen and paper. It helps them decide if a business deal is attractive enough to pursue.

What Is A Paper LBO?

Paper LBO is a condensed version of the full-fledged LBO model used by interviewers during private equity hiring to test a candidate’s analytical and decision-making skills.
It helps evaluate the feasibility of a transaction, given certain input and based on specific assumptions candidates make while studying prompts. A prompt is a scenario-based question.
Typically, candidates are required to build a paper LBO model within 10 to 20 minutes without using a calculator or spreadsheets.
The sections included are an acquisition summary, income and cash flow statements, assumptions, and returns calculations.

Paper LBO Explained

The paper LBO test is a popular interview question that interviewers use during private equity hiring to test a candidate’s mental and technical abilities. In addition, it also helps determine a candidate’s financial acumen and problem-solving skills. Beyond this, it enables interviewers to decide if a particular acquisition or merger is promising and potentially profitable. Further, it helps interviewers assess a candidate’s knowledge of private equity concepts.

The paper LBO model is a staple across private equity interviews, and it is widely used by financial and equity analysts. Candidates are required to build a basic paper LBO model in about 20 minutes based on a specific prompt. A prompt is a scenario presented by interviewers to a candidate. It can be hypothetical.

These prompts require candidates to dig deep and apply their analytical skills, as these questions usually comprise merger or acquisition scenarios involving diverse companies and varying complexities. A candidate’s acumen and agility in tackling unfamiliar situations determine their grasp on subjects like valuation, forecasting, cash flow, and even the Rule of 72.

Candidates are not allowed to use MS Excel or calculators during this process. They are expected to complete the task relying only on mental calculations. The numbers they derive through calculations can be rounded off to the nearest digit for accuracy. In its essence, this test requires candidates to determine and present a deal's profitability in a few minutes, armed only with a pen and paper. They may also be required to calculate the Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC).

Prompts can range from simple to challenging and include entities from small-cap tech startups to multinational conglomerates. The data given to candidates is usually in its simplified form. While prompts might appear straightforward, the model's complexity depends on the assumptions a candidate makes. Keeping these assumptions simple is essential to ensure the coherence and credibility of the model being presented. Excessively complex assumptions can introduce uncertainty and undermine the effectiveness of the analysis put forth by the candidate. Clear, concise, and realistic assumptions can ensure an effective and striking presentation during the interview.

How To Do?

Let us study the paper LBO steps on how to build a model in the easiest way possible.

Step #1 - Understand the prompt and determine transaction assumptions

The first step of the paper LBO test is to understand the prompt well and note the assumptions before building a model. The broad category of assumptions includes:

Valuation assumptions
Financing assumptions
Growth assumptions

They typically cover aspects like revenue, Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) multiple and its growth, purchase multiple, exit multiple, leverage multiple, capital expenditure, annual growth rate, etc. Taking these into account usually ensures that the prompt/hypothesis is tested properly.

Other crucial information about the deal is made available to candidates. It includes the acquisition date, purchase price, parties involved, capital structure, capital expenditure, and expenses, among other relevant data points.

Step #2 - Set up a template

Once the above details are ready, the next paper LBO step includes finalizing a template. The model has three basic sections: Acquisition Summary, Cash Flows, and Sponsor Returns. In the first section, determine the business's total cost or purchase price. This is usually calculated by multiplying the purchase multiple, a common valuation metric, by the company's EBITDA.

Step #3 - Finalize financing sources, prepare income projections, and perform cash flow analysis

This step involves financing the deal and estimating future earnings.

Determine the mix of debt and equity required to finance the deal. It can include senior, mezzanine loans, equity contributions from sponsors, etc. Also, ascertain the transaction fees, such as legal and advisory costs, since they impact cash flows.

The next section estimates the income statement for the holding period of 3 to 5 years. It starts with projecting revenue, often taking historical data and applying a growth rate, which is either available or computed. Next, calculate the EBITDA by subtracting the Cost of Goods Sold (COGS) and operating expenses from the revenue figure. After this, deduct applicable expenses. For instance, interest expense is applicable when funding sources include debt. In many cases, interviewers provide the EBITDA and the growth rate.

Step #4 - Forecast free cash flows

At this stage, a crucial metric called the Leverage Free Cash Flow (LFCF) is calculated. It is like the cash available to the company for the next few years after accounting for operating expenses, financing costs, and reinvestments. The formula is:

LFCF = Net Income + Depreciation & Amortization (D&A) - Capital Expenditure - Working Capital

Step #5 - Determine the debt paydown and IRR

The last step involves considering exit or sponsor returns by determining metrics like Purchase Enterprise Value (TEV), which combines the transaction value (calculated using the unleveraged multiple) with net debt. It is compared to the projected exit value estimated using the exit multiple and other assumptions to calculate measures like Multiple on Invested Capital (MOIC) and Internal Rate of Return (IRR). The equations for TEV, MOIC, and IRR are:

Purchase Enterprise Value (TEV) = LTM EBITDA × Exit multiple

Exit or Equity Value = TEV − Net Debt

MOIC = Cash sponsor receives / Sponsor equity investment

IRR = MOIC ^ (1 / year of investment) - 1

Since IRR requires detailed calculations in MS Excel, this equation is difficult to attempt without assistance. Therefore, the easiest way to calculate IRR is to use the Rule of 72. It means dividing 72 by the number of forecast years. For example, 72/5 is 14.4 or 14%.

Examples

Let us study a few examples of the paper LBO model to understand the concept.

Example #1

Suppose Paula is a financial analyst interviewing with Chase Investments Ltd. A prompt was presented to her, asking her to prepare a paper LBO model in 15 minutes. The following details pertaining to the deal between ABC Ltd (acquirer) and XYZ Ltd were given.

Details
ABC Ltd acquires XYZ Ltd for a purchase multiple of 5x (LTM EBITDA) for 12 months.
The revenues in 2022 were $600 million, with an annual growth rate of 10%.
EBITDA was $50, and the margin of 20% tends to remain flat throughout the investment.
Every year, D&A was $10 million. The debt was $200 million, and the cash was $120 million.
The tax rate was 45%, and expenses were 10%. Interest was $5 million.
Capital Expenditure was $10 million, and the change in working capital was $5 million yearly.

Paula prepared a paper LBO model using these details and created the following statements—an acquisition summary, a cash flow statement, a forecast, and a paper LBO debt paydown and IRR. She computed revenues and EBITDA for each year. Next, she computed the free cash flows, determined leverage, and calculated the exit value. Paula used the Rule of 72 to calculate the IRR.

Let us solve the paper LBO for private equity recruiting. The assumption Paula makes states that the forecast period is four years until the transaction deal.

Income and Cash Flow Statement

Particulars	Year 0	FY1	FY2	FY3	FY4
EBITDA	$50	$60	$72	$86	$103
(less) D&A		($10)	($10)	($10)	($10)
EBIT		$50	$62	$76	93
(Less) Interest		($5)	($5)	($5)	($5)
Taxes		($23)	($28)	($34)	($42)
Net Income		$22	$29	$37	$46
(Add) D&A		$10	$10	$10	$10
(Less) CapEx		($10)	($10)	($10)	($10)
Change In WC		($5)	($5)	($5)	($5)
Levered Free Cash Flow (LFCF)		$17	$24	$32	$41

Debt Paydown, MOIC, and IRR

Returns	Amounts
Year 5 EBITDA	$103
(Multiply) Exit Multiple	10x
Enterprise Value or TEV	$1030
(Less) Debt	($250)
(Add) Cash	($120)
Exit Equity Value	$660
(/) Equity Investment	$200
MOIC	3.3x
IRR	28%

Since the multiple of invested capital is 3.3x, the estimated IRR is 28%.

Example #2

Suppose Simon is presented with the following prompt during his interview with Starlight Investments Ltd.

Company: Criss Widgets Ltd.

Industry: Industrial Manufacturing

Investment Bank: Starlight Investments Ltd.

Acquirer: ABC Company

Information:

EBITDA: 2022 - $45 million
Revenue Growth: 7% per year
EBITDA Margin: 25% (assumed constant)
Capital Expenditures: $8 million per year
Net Working Capital: No change expected
Debt: $150 million (fixed)
Cash: $10 million (fixed)
Tax Rate: 40%

Simon analyzed the information and arrived at the following action plan:

He decided to build a basic LBO model for 5 years; it means he plans to prepare the income statement and cash flow projections for the next 5 years.
He outlined the potential risks, alternative financing options, and exit strategies through certain assumptions.
After calculating the required figures, including IRR, Simon presented his findings and recommendations to the interviewers at Starlight Investments Ltd.

Paper LBO vs Full LBO Model

A paper LBO is a mini version of the full-fledged LBO model. Here are the differences between them.

Basis	Paper LBO	Full LBO Model
Meaning	It refers to LBO models prepared on paper during interviews by candidates without using a calculator.	The full LBO model refers to the detailed version of the leveraged buyout model.
Purpose	Its purpose is to assess the skills of a candidate by asking them to calculate the viability and profitability of a transaction without using a spreadsheet.	The purpose of a full LBO is to determine the maximum value a buyer must pay to close the deal. A few other objectives include risk assessment, financial analysis, and negotiation strategy.
Tools and skills requirements	A pen and paper are made available to a candidate for this task. Candidates make assumptions and rely on mental calculations to arrive at potential recommendations.	In this case, financial reports, statements, spreadsheets, market data, etc., are available for analysis.
Forecast period	The forecast period is usually 3 to 5 years.	In a full LBO model, the period can range from 3 to 7 years.
Modeling period	The model must be prepared in 10 to 20 minutes.	It can vary based on several factors, such as an analyst’s experience, team size, market conditions, the complexity of transactions, etc.

Frequently Asked Questions (FAQs)

1. How to calculate IRR in a paper LBO?

As calculators are not allowed while solving a prompt in a paper LBO, certain assumptions can help determine the IRR. For example, for a Multiple of Invested Capital (MOIC) of 2x, the IRR is 15% for 4 to 5 years.

2. What is the Rule of 72 in paper LBO?

The Rule of 72 is a rule of thumb that states that in the absence of a calculator, the time for an investment to double is 72/the number of years. Divide 72 by the number of holding years to get a ballpark Internal Rate of Return (IRR). For instance, to get the IRR for a holding period of 4 years, divide 72 by 4. The estimated IRR will be 18%.

3. How long should a paper LBO take?

The time each candidate takes usually differs based on their ability and experience. However, such tests must be completed within the allocated time. For instance, most interviewers give candidates around 15 to 20 minutes for this task.