How to Do a Paper LBO: A Step-by-Step Walkthrough

A leveraged buyout (LBO) involves acquiring a company using a substantial amount of borrowed money. This debt is secured by the acquired company’s assets and future cash flows, allowing the acquiring firm, typically a private equity group, to gain control with a relatively smaller equity investment. Performing a “paper LBO” is a conceptual exercise designed to understand the fundamental mechanics, financial modeling, and key value drivers of such a transaction without the need for complex software. It serves as a simplified approach to quickly estimate potential returns and grasp the underlying financial principles involved.

Core Inputs and Assumptions

Before constructing a paper LBO model, a comprehensive set of inputs and assumptions must be gathered. This preparatory phase establishes the foundation for all subsequent financial projections.

Initial financial data for the target company is necessary, including historical income statements, balance sheets, and cash flow statements. These provide a baseline to analyze past performance, identify trends, and formulate realistic forward-looking projections.

Transaction assumptions define the acquisition itself. The purchase price is often determined as a multiple of the target company’s last twelve months (LTM) EBITDA, frequently falling within a range of 5x to 10x EBITDA for middle-market companies. The sources of funds outline how the acquisition is financed. Senior debt, typically the least expensive capital, is secured by the company’s assets. Mezzanine debt, ranking below senior debt, is riskier and thus carries higher interest rates, often including payment-in-kind (PIK) interest features or equity warrants.

The equity contribution from the private equity firm represents the riskiest portion of the capital structure, typically ranging from 20% to 40% of the total transaction value. The uses of funds detail how the capital is deployed, encompassing the purchase price, transaction fees (which can be 2.0% to 2.5% of the transaction value), and financing fees (around 2.0% to 2.5% of the debt amount). These fees cover advisory, legal, and lending costs.

Operating assumptions project the target company’s performance post-acquisition. This includes expected annual revenue growth rates, often based on historical performance and industry outlook. Cost of Goods Sold (COGS) and operating expenses (excluding depreciation and amortization) are commonly modeled as a percentage of revenue. Capital expenditures (CapEx) for asset maintenance and growth, along with depreciation and amortization (D&A), are estimated. Changes in working capital, such as accounts receivable, inventory, and accounts payable, are also projected.

Debt assumptions detail the terms of each debt tranche, specifying interest rates and amortization schedules. Senior debt often requires regular principal repayments, while mezzanine debt might have a bullet payment at maturity or utilize PIK interest. A revolving credit facility, if included, provides flexible short-term liquidity for operational needs.

Finally, exit assumptions are crucial for valuing the investment, projecting the company’s sale. This involves an assumed exit multiple, typically applied to the projected EBITDA in the exit year, and the expected exit year itself, usually within a 3- to 7-year timeframe.

Constructing the Financial Projections

Building the financial projections for a paper LBO involves a methodical process of linking various schedules and statements.

The first step involves creating a Sources & Uses table. This table itemizes where the capital for the acquisition originates and how that capital is allocated. It is fundamental that total sources precisely equal total uses, ensuring the transaction is fully funded and balanced.

Following this, a detailed debt schedule is constructed for each type of debt. This schedule tracks the beginning and ending balances of each debt instrument, calculates interest expense, and accounts for principal repayments. Interest expense from this schedule flows directly into the income statement, while principal repayments are reflected in the cash flow statement.

Projecting the income statement begins with forecasting revenue. COGS and operating expenses are then calculated as percentages of revenue, leading to EBITDA. Depreciation and amortization are subtracted from EBITDA to arrive at Earnings Before Interest and Taxes (EBIT). Interest expense from the debt schedule is then deducted to calculate Earnings Before Tax (EBT). Taxes are applied to EBT using the appropriate corporate tax rate. The final result is net income.

The cash flow statement is then projected, starting with net income. Non-cash expenses like depreciation and amortization are added back. Changes in working capital are incorporated. Capital expenditures are subtracted as a cash outflow from investing activities. Debt principal repayments from the debt schedule are included as cash outflows from financing activities, leading to the net change in cash for each period.

The balance sheet is projected by linking its line items to both the income statement and cash flow statement. Assets like cash are directly linked from the cash flow statement. Accounts receivable and inventory are often tied to revenue and COGS. Property, plant, and equipment are updated by adding capital expenditures and subtracting depreciation.

Liabilities such as accounts payable are linked to COGS, and debt balances are carried forward from the debt schedule. Equity is typically calculated by taking the prior period’s equity, adding net income, and subtracting any dividends.

Valuing the Investment

The final stage of a paper LBO involves calculating and interpreting key performance metrics to assess the investment’s attractiveness.

The exit value calculation determines the projected sale price of the company at the end of the investment horizon. This is typically achieved by applying the assumed exit multiple to the projected EBITDA in the specified exit year.

Subsequently, the net debt at exit is determined by summing the remaining principal balances of all debt tranches outstanding at the time of sale. The equity value at exit is then calculated by subtracting this net debt from the enterprise value at exit. This figure represents the cash proceeds distributed to the private equity firm’s equity investors.

The Multiple on Invested Capital (MOIC) is a straightforward metric that indicates how many times the initial equity investment is returned. It is calculated by dividing the equity value at exit by the initial equity contribution. A MOIC greater than 1.0x indicates a profitable investment, with a MOIC of 2.0x or higher generally considered a successful outcome in private equity.

The Internal Rate of Return (IRR) measures the annualized rate of return on the equity investment, taking into account the time value of money. It represents the discount rate at which the Net Present Value (NPV) of all cash flows related to the equity investment equals zero. Private equity investors frequently target IRRs of 20% or higher.

While a detailed sensitivity analysis is typically performed using financial modeling software, it is important to conceptually understand its purpose. This involves considering how changes in key assumptions, such as revenue growth rates, the exit multiple, or the initial purchase price, could impact the calculated MOIC and IRR. This conceptual understanding helps to identify the most impactful drivers of value.