# Mastering Paper LBO Tests: A Comprehensive Guide

Private Equity firms often employ “paper LBO” tests to gauge a candidate’s financial modeling capabilities. In this article, we uncover the essence of these tests, provide key tips for acing them, and present a real case study to illustrate the process.

## Understanding Paper LBO Tests

Paper LBOs differ from traditional financial modeling tests. While the latter usually involves Excel-based exercises, paper LBOs resemble mental math puzzles. The objective is to approximate the Internal Rate of Return (IRR) or money-on-money multiple without relying on calculators or spreadsheets.

To succeed in paper LBO tests, rounding and simplifying numbers is crucial. Completing complex calculations within the given time limit (often 30 minutes) requires a strategic approach. Moreover, always keep the end goal in mind. For example, if the target IRR is 25% over 5 years, you should know that it corresponds to a 3x multiple of the initial investor equity.

Simplifying transaction assumptions is also recommended. Ignore transaction and financing fees, assume cash-free and debt-free deals, and consider that the target company’s cash and debt immediately become zero after the deal closes. Additionally, assume that the debt issued to fund the leveraged buyout remains the same or that 100% of the company’s free cash flow is used to repay the debt principal. Intricate assumptions make calculations challenging when using pencil and paper.

## Real Case Study: Analyzing a Paper LBO Example

In the provided paper LBO case study, a private equity firm aims to acquire a company at a 10x EBITDA multiple, using 6x debt to fund the deal. The firm targets a 20% IRR over 5 years, requiring a thorough analysis to recommend or reject the deal based on this target.

Let’s break down the case study into key steps and explore the solutions.

## Step 1: Determine the End Goal

The targeted 20% IRR over 5 years translates to an approximate 2.5x multiple of invested capital. This understanding helps set the stage for further calculations.

## Step 2: Project Revenue and EBITDA

Using the provided initial numbers and approximations, we can estimate Revenue and EBITDA for each year. By applying simple percentage increases to the initial figures, we arrive at reasonable approximations.

## Step 3: Calculate the Annual Free Cash Flow

In this simplified “model,” we define Free Cash Flow as EBITDA minus interest, taxes, change in working capital, capital expenditures, and purchases of intangibles. By grouping percentages of revenue together, we simplify the calculation. Completing this step results in a comprehensive chart of the initial Free Cash Flow estimates.

## Step 4: Calculate the Exit Proceeds

To conclude the analysis, we calculate the Exit Enterprise Value, Exit Equity Value, money-on-money multiple, and IRR. Given the Year 5 EBITDA and the Year 5 Exit Multiple, we determine the Exit Enterprise Value. The absence of information regarding the cash balance assumes no change, thanks to the complete utilization of the company’s free cash flow for debt repayment. Based on the remaining debt in Year 5, we derive the Exit Equity Value, allowing us to determine a range for the multiple. Comparing the resulting range with the target 2.5x multiple, we find that the deal is not viable.

## Excel Format and Importance in Private Equity Interviews

While we provide approximations for the calculations, an Excel version of the paper LBO is available for download. However, it is important to note that completing the test using pencil, paper, and mental calculations is the intended purpose. Employers administer paper LBO tests primarily in earlier rounds of interviews, and while practicing them is beneficial, it is crucial to allocate time to hone other essential skills, such as storytelling and deal experience discussions. Ultimately, acing a paper LBO test won’t guarantee a job offer, but performing poorly could jeopardize one.

In conclusion, paper LBO tests present a unique challenge in the private equity interview process. By adhering to key tips and thoroughly analyzing real case studies, candidates can enhance their performance and set themselves up for success.

To learn more about Quill And Fox’s expertise in private equity and financial modeling, visit Quill And Fox.