THE PAPER LBO ‘The following example corresponds to the accompanying Excel file titled “WSO -PE Guide — Paper LBO Example 1 xlsx ‘The Paper LBO is a simplified version of the LBO that is designed to test your understanding of the logic and basic mechanics of buyouts. These questions can come in the middle of both first round and later stage interviews. Your interviewer will give you some basic assumptions and deal details, and ask whether this deal is attractive. You then can walk your interviewer through the rough calculations of the Paper LBO, and after generating a deal IRR you can ‘comment on the attractiveness of the deal. ‘A few quick points before we jump into the mechanics. First, the interviewer may not give you all of the assumptions you need up front. This is fine; they are looking to see whether you know what the missing terms are to ask for or whether you can make reasonable assumptions about them (e.9., “Do you know what the tax rate is here? Or should | just assume 40%?"). ‘Second, this is always 2 simplified version of the LBO and is designed to get you in the ballpark of the deal IRR; do not be afraid to round numbers as necessary, because giving an IRR to the third decimal point is an exercise in false precision. Third, if you are comfortable doing the math in your head that is great, but do not feel ike you absolutely have to. Finally, this is an exercise where you are trying to show your thought process and understanding of the mechanics; as you are making your calculations, explain what you are doing to the interviewer so they can follow along. Paper LBO Example Your interviewer opens with the following: “Let's say we're looking at a company that did ‘5200M in revenue last year and has a 25% EBITDA margin. We could buy it for 6x EBITDA with 75% debt, and sell it for 5x EBITDA in 5 years. We expect EBITDA to grow at 10% during ‘ur hold period. Does this look like a good deal?” ‘You have gotten most of the information you will need to do the Paper LBO, but not all of it. However, you have enough to do the first step of the Paper LBO: the Deal Entry Calculation. - Deal Entry Calculation0 Multiplying revenues ($200M) by the EBITDA margin (25%) will give you LTM EBITDA at the time of the deal ($50M)_ © Multiplying LTM EBITDA (850M) by the EBITDA multiple (6x) gives you the initial TEV ($300M) ‘2 Multiplying the TEV ($300M) by the debt percentage (75%) gives you the implied debt ($225M). The remainder (S75M) is the size of the equity check at entry. © An Excel version of how your paper may look when you have finished this step may look like this: Entry Calculation LTW Revenue $200.0 x EBITDA Margin 25.0% LIMEBITDA $60.0 x Entry Multiple 60x Entry TEV $300.0 bess: Debt ($225.0) Entry Equity 575.0 ‘The next step is to project the financials and cash flaw of the business during the hold period, or the Forecasted Financials. This is important to understand both how much cash the business will generate while you own it, as well as to understand the price you will get for the business at exit (which here will be based on a muttiple of EBITDA at exit). However, you do not have enough information to complete this step yet. At this point you should ask your interviewer about the cost of debt, the debt paydown policy, the tax rate, capex, D&A, and net working capital. ‘Your interviewer responds with: “Let's keep it simple. The cost of debt will be 10%, and we'll assume that we don't pay down any debt during the hold period and instead take cash out at the end. The tax rate is 40%, and capex and D&A are both $15M per year. Net working capital increases by $5M each year.” ‘You now have the information to project the Forecasted Financials during the hold period. Forecasted Financials ‘9 Income Statement "We calculated above that LTM EBITDA was $50M. Given the 10% growth rate, we can calculate EBITDA for years 1-5 by multiplying each prior yearby 4.1. Doing this we calculate EBITDAs of $55M, $60.5M, $66.6M, $73.2M, and $80.5M for years 1-5 respectively. Daa is steady at $15M per year, so we can populate that for each year. Subtracting D&A from EBITDA, we get EBITS of S40M, $45.5M. $51.6M, $58.2M, and $65.5M for years 1-5. Calculating interest in this situation is as simple as multiplying the amount of debt (calculated as $225M in the Deal Entry Calculation above) times the cost of debt (10%) to yield $22.5M. Because we are net paying dawn debt during the hold period, it is the same each year. Subtracting interest from EBIT gives us EBTs of $17.5M, $23M, $29.1M, $35.7M, and $43M for years 1-5, Taxes are then calculated as 40% of EBT for each year. These will equal $7M, $9.2M, $11.6M, $14.3M and $17.2M respectively. Subtracting taxes from EBT will give us our Net Income each year: $10.5M, $13.8M, $17.4M, $21.4M and $25.8M. This gives us our Income Statement. An Excel version of your paper may look like this: Year ° 2 z 2 4 5 Icons Stabernant ‘EBITDA $50.0 $55.0 $60.5 6G $732 $20.5 % Growth (10.0% 10.0% 10.056 10.0% 10.0% Less: D&A (S150) (5150) (6150) S50) (315.0) EBIT $40.0 S455 S516 $58.2 365.5 Less: Interest BT Less: Taxes Net Income 4522.50) ($2250) ($2250) ($22.50) _ ($22.50) $i7.s $23.0 $29.1 $35.7 M30 (S72 ($92) Se) Gas) (S72) $10.5 $8 s74 $24 $25.8 © Cash Flow From here we can calculate cash flow. We will start with Net Income calculated above, To this we add back D&A of $15M each year. We then subtract capex of $15M each year. Finally, we subtract an increase in NWC of $5M each year.* This will give us a Cash Flow line of $5.5M, $8. 8M, $12.4M, $16.4M, and $20.8M in years 1-5 respectively. = We can sum across the Cash Flow line to see that cumulatively the business will generate $64M in cash during the hold period, which we will receive at exit. * An Excel version of your paper may look like this: Year o 1 2 3 4 5 Cash Flow Net income sus sag SaaS B Plus: D&A $15.0 $15.0 $15.0 $15.0 $15.0 Less: Caper (50) 150) GSO) ($150) (5150) less: Change in NWWC ($0) (S50) ($5.0) ($50) (550) Levered Cash Flow: $55 $88 S14 $16.4 $208 Cumulative Cash Flow: ss $142 $26.7 M32 $64.0 ‘We're almost done. All we have left is the Deal Exit Calculation and your recommendation, - Deal Exit Calculation ° ° At Exit, we know LTM EBITDA will be $80.5M (Year 5 EBITDA from above), Multiplying LTM EBITDA at exit ($80.5M) by our Exit Multiple (5x) will give us our ‘exit TEV ($402.5M). To this figure, we add our cumulative cash generated ($64M) and subtract our debt (still $225M) to get an Exit Equity value of $241.5M. Next we must calculate our Multiple on Invested Capital (MOIC) / Multiple of Money (MoM). To do this we divide the Exit Equity value by our Entry Equity (8241.5M/$75M) to yield 3.2x. Finally, to convert the 3.2x MOIC into IRR we can do one of two things: "We can calculate it by using the typical CAGR formula. We take our MOIC * ({/HHold Period) — 1. In this case: 3.2 * (4/5) - 1, giving us an IRR of 25.4%.* Altematively, we can rely on the rough heuristic table below: a2 3 a] Ox Soe Oe am Ls] SOCK 225K ASK AT 70% Qo] wos sues 8m Le aa2% 3] = ‘ome os 4% 2s] soos sax asm asm) max] assK m6 ux Dox ome ao] 200% ZR 202% ase 200% S728 SL me 2a Ao] 200% 100K SEM AL, 26.0% We see that a 3x deal over five years yields around a 25% IRR, while a 3.5x deal is almost 29%. Thus, for 23.2x deal we can assume an IRR around 26%. This level of precision should be fine fora Paper LBO. (In fact, you should memorize the year 5 column of this grid for your own reference, regardless of how you choose to calculate IRR during a Paper LBO. Knowing that a 2x deal is a 15% IRR, a 2.5x deal is a20% IRR, and a 3x deal is a 25% IRRis quite useful.) An Excel version of your paper may look like: OKC Generated SEEGER. Exit Calculation LM earrDa, soos x Exit Multiple 5.0% jw CMDS Plus: Cash Generated $64.0 (5225.0 $241.6 morc 32x RR 64% The final step is to provide a recommendation. This specific deal looks good, with a 3.2x MOIC: and a 26% IRR. However, you may want to comment on whether this risk adequately ‘compensates you for the risk you are carrying (¢.9., if faced with a deal that has a 19% IRR, you may comment “This deal looks to be decent, but it depends on how risky the business is. If this is a very safe business, I'd be more comfortable pulling the trigger here and accepting a high-teens retum.”) You may also want to comment on what is important to make the deal a ‘suecess and how that would affect the way you diligence the business (¢.g., here you might say “This deal looks great with a 26% IRR, but we would have to dig in during diligence to get ‘conviction around the 10% EBITDA growth. Cash flow generation provides some of the returnhere, but this is primarily an EBITDA growth story.”). This kind of analysis is pretty basic, but it lets you to show some of your investment judgment rather than just your math skills. One final comment on the Paper LBO is to be aware that there are a number of twists that can be thrown into these questions. For example, rather than asking you what the IRR of a given deal is, the interviewer may ask you what the exit multiple must be given a set of assumptions to get a 20% retum ona deal, or what price you could pay at entry to receive a target retum. ‘They also may ask you to include things that have been simplified away in this case, like including management options or deal fees. Ultimately, the mechanics of the exercise will be the same, but you'll be solving for a different variable or adding a few additional line items. Don't get caught off guard by these tweaks; just calmly walk through the mechanics and show you can deal with anything they throw your way.