How to do a Paper LBO (MUST Know for Private Equity)

the paper lbo is one of the most popular questions you'll get in private equity interviews at the analyst associate and senior associate level the reason why it's so popular is because it tests all of the key mechanics of an lbo which is the key model in private equity but it's very easy to administer you can do it either orally or just giving someone simple instructions so in this video we're going to explain how to do the paper lbo the format that it typically comes in all the mechanics that you need to know and then we'll go through an actual paper lbo question and this video is a sample of the private equity recruiting course which covers how to build an lbo in excel as well as how to do case studies in order to properly build a paper lbo we're going to cover the following concepts enterprise value sources and uses forecasting financials free cash flow and the rule of 72. so let's start by talking about the format of the paper lbo and as the name suggests it's completely done on paper you don't have to open excel at all so in a typical paper lbo these are the rules the interviewee will complete financial forecasts by hand they'll typically be given less than 15 minutes to complete the entire thing the numbers provided will be relatively simple to compute so you're not going to get very strange decimals or very difficult numbers and you'll also be allowed to liberally round numbers so now let's cover the steps that you need to compute a paper lbo and this is not just for paper lbos this is for every lbo every investment model in the world and i just want to impart on you the first principles whenever you're building an investment model really what you want to be aware of is how much money you put in and how much money you're getting back there's a bunch of other factors but it ultimately boils down to the simplicity of how much money you're making atop your own investment so there's three main steps i would say when doing an lbo the first is determining the transaction assumptions an lbo is a negotiated deal and that means two parties will have to have agreed on a specific price with specific terms so the first question very simply is how much are we purchasing the company for if we're doing an lbo which stands for leverage buyout that essentially means we are buying an entire business or an entire asset and as such we need to know how much total money is being deployed to purchase this business and the next question is how much debt and how much equity is used to purchase the company this is really important because the equity amount is going to represent what we as equity investors have to put up it's very similar to putting a mortgage on a house when you take out a mortgage that's the debt piece that we'll be concerned with and then we have the equity piece which represents the investment that we will put in and that's another big corporate finance rule whenever you're financing any kind of business or an acquisition it can either be done in debt or equity the next step is to forecast out the financials and actually for an lbo all we really need is an income statement all the way down to free cash flow so we don't have to do an entire three statement model in fact a lot of the times you'll find that this is actually relatively simple it'll only be about seven or eight lines of actual arithmetic so a real exercise here is to see how long we intend on holding the investment and private equity on average it's probably between five and seven years but for a paper lbo often times i've seen it's closer to three to five years because it's just easier to compute fewer numbers and our ultimate purpose here is to see how much free cash flow this asset or this business is going to generate over that time span and the principle here is that we are going to be using cash generated from the asset or the business to pay down the debt and finally the third step is to calculate the debt pay down over the forecast as well as the returns analysis now this sounds complicated but it's going to be a direct result of what we just calculated the first thing we're going to do is look at how much debt was paid down in the forecast the second thing is to look at how much cash we are getting back on our investment remember that this figure is essentially the key item we've been looking for this entire time we want to look at the end the investment period after we have held the business how much cash we're getting back and finally we're going to take these numbers put it into a clever formula called the rule of 72 and use that in order to determine the return profile of the investment so i hope you followed up to this point because we're about to dive into an example question so this i would actually say is a relatively simple paper lbo something they might administer during an analyst level interview so assume that we are a private equity firm purchasing company alpha at the end of 2021 the purchase multiple is 10 times ltm ebitda the company has 200 million dollars of revenue in 2021 which grows at 25 million dollars annually even the margins of 50 that remain flat dna and capex both 10 of revenue also flat throughout the forecast no change in networking capital the tax rate is 50 which makes it simple to calculate the initial leverage which is how much debt we're gonna put on the business is five times ltm ebitda we have an interest rate of 10 percent which is going to be applied on the debt and we're going to assume an exit after three years of projections at 10 times ltm ebitda and that's all the information you need to calculate the irr and mom of the business so why don't you pause right here if you want to try it and then we're going to start jumping into the answer so the first thing is to look at how much the company costs how can we figure this out well we have the purchase price multiple which is 10 times ltm ebitda now if you remember from the comps video what we have to do here is multiply this by ebitda but we're not giving ebitda directly so what we have to do is multiply the figure of 200 million dollars in revenue that's how much we generated in 2021 and we're going to multiply that by the constant ebitda margin of 50 so 200 times 50 is 100 million dollars 100 million is our ltm ebitda ltm is the last 12 months and then we multiply 100 by 10 to get to a 1 billion dollar purchase price so this is that first item this is how much it costs to buy the entire business if you were selling your family business for a billion dollars this is how much total cash you would be getting now the next piece is to figure out how this was financed again think about the house analogy how much of this was a mortgage how much did we put up of our own cash and we're told this amount in the initial leverage multiple of five times so we take 5x multiplied by 100 million and that means we have 500 million dollars of debt and if you know your corporate finance you know that everything else has to be financed by equity because we only have two options debt or equity in this relatively simple construction and this also tells us that our initial investment is 500 million dollars so we are deploying 500 million dollars of capital and just fyi this is probably where that upper middle market kind of price range begins a lot of these upper middle market private equity firms are deploying this amount of capital so the next step is where we're going to do a lot of the arithmetic we're going to forecast out the income statement and cash flow statement starting with revenue we essentially have to go from revenue to free cash flow and we're given the simplest items possible so what we're going to do is revenue to ebitda we're going to deduct dna and interest and we're going to calculate what tax is to get to earnings essentially and finally once we're at earnings we're going to add back dna because it's a non-cash expense and then we're going to deduct capex because that's a cash outflow so let's walk through each step so you understand it so the very first thing i would do in a paper lbo is just get out all the years we start with 2021 and we're going to write that until 2024 so we have three years of forecasted financials in the first year which is essentially year zero in 2021 it's 200 million dollars and we'll go 225 250 to 75 and that's because it's 25 million dollars every single year so for ebit of what i'm going to do first i'm going to write the margin i know it's 50 held constant and then i'm going to multiply that out for each of the ebitda figures so here's what i would calculate as the numbers and it doesn't have to be perfect but we would have 100 million in 2021 about 113 in 2022 125 and 2023 and maybe call it 138 or 140 is fine for 2024. so after we have ebitda the next thing we're going to do is deduct dna because it's still an income statement expense and we need to deduct it in order to calculate taxes properly this is kind of a complex concept that we again cover in the course i'm not going to dwell upon it here but it's something you do need to understand and for dna we only need this in the forecasted years we don't really need to know it for 2021 because we don't need free cash flow in year zero so i'm just going to multiply this out for dna it's roughly 23 million and 25 million and then 28 million so the next calculation we need to do is calculate interest we're going to go from ebit to ebt so for interest we are going to multiply the initial debt which we calculated in the first step of 500 million dollars and multiply that by 10 percent and that means we have 50 million dollars in interest every single year the prompt tells us that we don't have to pay down debt over time so it's going to be a flat 50 million so why don't we pause here and roughly do some of these calculations so we get to ebt which is earnings before taxes so if you see this arithmetic we can really start at the ebitda level and we're going to deduct dna so 113 minus 23 is roughly 90 million 125 minus 25 that's an easy one of 100 million and 138 or 140 call it minus 28 gets us to around 110. and i think you should be comfortable doing that level of arithmetic in your head it's not hard it's just something you need to get practiced with so after ebit we're going to deduct the same interest figure across the board so we'll go 90 minus 50 100 minus 50 110 minus 50 and that gets us to 40 50 and 60. again these are round numbers and what we have to do next is deduct taxes now we've made the tax rate also easy at fifty percent so you're just going to divide by two just a straight divide by two so then we'll get from 40 divided by two to 20 50 divided by two to 25 and 60 divide by 2 to get to 30. so we're almost there the last couple things we need to do are account for dna capex and change in operating capital but we've made this again easy for you because dna and capex as you remember are both 10 of revenue so they net against each other meaning you don't have to do anything and change in networking capital is actually zero so in this particular example net income is the same as free cash flow so we can actually just take those net income figures we just computed and we're done the arithmetic portion of the lbo so i will say that that part is definitely going to be the time consuming part of the paper lbo expected to take well over 50 of the entire question so the third part is to calculate the debt pay down and the returns so for the debt pay down we're essentially wondering how much cash did this business generate because we're gonna use that to pay down all of the debt at the end of the forecast and how do we get that that's simply the cumulative numbers of free cash flow so we're gonna add up 20 25 and 30 that gets us to accumulate a free cash flow of 75 million dollars we then go back to the first numbers we calculated we started with 500 million dollars in debt and then we're going to deduct 75 million bringing us to 425 million dollars in ending net debt so we'll hold on to this number for a second the next thing we have to do is determine the exit price of the business essentially this is the total value that we're going to sell the business for we've held the business for three years we've improved it ebitda has grown and now it's time to sell it to maybe another private equity firm or a strategic acquirer and because it's ltm ebitda we can actually just take 2024 ebitda which is 138 million dollars we're then going to do 138 multiply by 10 because we're told that is the exit multiple and that gets us to about 1400 million dollars in terms of exit enterprise value and this exit enterprise value for our purposes we can think of as our full sale price now in a normal lbo there might be a bunch of other annoying stuff like fees or options or other kind of mechanics but for most simple paper lbos it's going to be straight enterprise value as the sale price so we're going to take that 1400 million dollars and deduct the net debt figure that we just calculated which is 425 and this is where i think you can kind of liberally round that's about 1400 minus 400 and that would bring us to about 1 billion dollars in terms of exit equity value now if you remember and relate this all back to the first kind of principle we were thinking of we wanted to know how much cash we're going to get at the end of our investment and we're going to compare that to our initial investment and this is the final part so what we're actually just going to do here is divide so we're going to take our exit equity value and divide it by our initial equity value so 1 billion divided by 500 million which is our initial investment and that's two times so that is our first very important investment metric we've made a two times multiple of money now the next thing we have to do and this is the clever calculation but there is a mathematical phenomenon called the rule of 72 and essentially what it means is that if you take the number 72 and divide it by the number of years that you're holding an investment or an asset or a number then if you divide those numbers it just so happens that that is the implied compound growth rate or as we like to call it in private equity the internal rate of return so this is the other really important private equity metric the internal rate of return essentially tracks how fast an investment grows on a year-over-year basis so what we're going to do is essentially 72 divide by three years of holding and you can be very kind of approximate with this it's around 24-25 if you think about it you can round 72 up to 75 divide 75 by 3 that gets you to about 25 percent so the answer to the paper lbo is two times mom and 24 25 irr and just for your context i would definitely describe that as a top quartile private equity return getting two times your money in three years is very good anything over 20 irr in this environment is also very good so i hope this was very helpful for you this is something that definitely requires a lot of practice to get better but trust me it's very important to know for all of your private equity and buy side interviews thanks for watching and i will see you in the next one [Music]

Channel: Peak Frameworks

Views: 115,927

Keywords: finance, investment banking, investments, career, business, private equity, salary, investment banking pay, wall street, valuation, mergers and acquisitions, financial careers, kkr, blackstone

Id: mIH-3bgocTQ

Length: 13min 47sec (827 seconds)

Published: Thu Dec 23 2021