Purpose of a paper LBO
A paper LBO tests whether the candidate understands the economics without relying on spreadsheet machinery. The calculations are approximate, but assumptions and units must be clear.
Step one: entry value and equity
Multiply entry EBITDA by the purchase multiple to estimate enterprise value. Subtract or add relevant cash and debt if the prompt requires an equity bridge. Determine debt financing and sponsor equity.
Example: $100 of EBITDA at 10.0× implies $1,000 of enterprise value. If debt is 6.0× EBITDA, debt is $600 and sponsor equity is approximately $400 before fees and other uses.
Step two: operating growth
Estimate exit EBITDA from revenue or EBITDA growth. If EBITDA grows 8% annually for five years, a quick approximation can use the rule of 72 or direct multiplication. State the method.
Step three: debt paydown
Estimate annual cash available after interest, taxes, capex, and working capital. Multiply by the holding period or build a simple year-by-year schedule when interest decline matters. Don't assume all EBITDA converts to debt repayment.
Step four: exit value
Apply the exit multiple to exit EBITDA. Subtract remaining debt to determine sponsor proceeds.
Step five: returns
MoM equals exit equity divided by initial equity. Approximate IRR using known relationships: 2.0× over five years is about 15%; 2.5× is about 20%; 3.0× is about 25%. Use exact calculation if available, but explain the intuition.
Interpretation
State whether return comes from growth, debt paydown, or multiple change. Identify the assumption with the greatest downside impact. A correct IRR without interpretation is incomplete.
Common variants
Interviewers may ask for the maximum entry price at a target return, the leverage required at a known price, or the return under changed exit assumptions. Keep the setup organized so one variable can be changed without restarting.
Worked five-year example
Assume a company has $100 million of entry EBITDA and is acquired for 10.0× EBITDA, producing a $1.0 billion enterprise value. The transaction uses 6.0× debt, or $600 million, and approximately $400 million of sponsor equity before fees. To keep the illustration focused, assume fees are excluded from the first pass and there is no excess cash.
Suppose EBITDA grows from $100 million to $140 million over five years. The exit multiple remains 10.0×, so exit enterprise value is $1.4 billion. During the hold, the business repays $250 million of debt, leaving $350 million at exit. Sponsor equity proceeds are therefore approximately $1.05 billion:
- Exit enterprise value: $1.400 billion
- Less remaining debt: $350 million
- Exit equity value: $1.050 billion
- Initial sponsor equity: $400 million
- Money-on-money return: 2.63×
- Five-year IRR: approximately 21%
The return can be decomposed into two main sources. EBITDA growth raises enterprise value by $400 million at an unchanged multiple. Debt repayment adds $250 million to equity value. There is no multiple expansion. This decomposition matters because a case supported by operating improvement and cash generation is different from one that requires the exit market to become more generous.
Building the debt-paydown estimate
The fastest defensible method is to estimate cash available for repayment from EBITDA:
EBITDA
– cash interest
– cash taxes
– capital expenditures
– increase in working capital
– other recurring cash uses
= cash available for debt repayment
Interest should decline as debt is repaid. In a short interview problem, the prompt may permit a simplifying average-interest assumption. State it. If $600 million of debt carries an 8% initial rate, first-year interest is about $48 million. If debt declines steadily, average annual interest over the hold may be materially lower. A flat $48 million assumption is conservative but shouldn't be presented as exact.
Capital expenditure must reflect the type of business. A low-capital software company and an equipment-intensive manufacturer don't convert EBITDA into cash at the same rate. Working capital can consume cash in a growing business even when earnings rise. Taxes should be based on taxable income rather than EBITDA when enough information is available.
Reverse-solving the entry price
A common variation asks what the sponsor can pay while still earning a target return. Work backward:
- Estimate exit EBITDA and apply the exit multiple.
- Subtract estimated remaining debt to calculate exit equity value.
- Divide exit equity by the equity multiple required for the target IRR and holding period.
- Add the debt available at entry to calculate the maximum enterprise value.
- Divide by entry EBITDA to calculate the maximum purchase multiple.
For example, a 20% five-year target requires about a 2.49× equity multiple. If expected exit equity value is $1.0 billion, the sponsor can invest roughly $402 million of equity today. If financing provides $600 million of debt, maximum enterprise value before fees is approximately $1.002 billion.
Return anchors and their limits
Useful five-year approximations include:
- 1.5× MoM: about 8% IRR
- 2.0× MoM: about 15% IRR
- 2.5× MoM: about 20% IRR
- 3.0× MoM: about 25% IRR
The same MoM produces a higher IRR over a shorter hold and a lower IRR over a longer hold. A 2.0× return in three years is roughly 26%; the same return in seven years is roughly 10%. Timing is therefore not a footnote.
Common paper-LBO errors
The most common errors are mixing enterprise and equity value, treating EBITDA as cash flow, forgetting fees, assuming debt repayment above available cash, using the wrong exit metric, and quoting an IRR without explaining its drivers. Another frequent mistake is silently assuming multiple expansion. Entry and exit multiples should be written explicitly even when they are equal.