Paper LBO
The 5-10 minute napkin math approach to evaluating an LBO, step by step with a worked example
~25 min read
A paper LBO is a simplified, back-of-the-envelope LBO analysis that PE professionals (and interview candidates) are expected to perform in 5-10 minutes with nothing more than a pen, paper, and a few key assumptions. It strips away the complexity of a full operating model and focuses on the essential math: entry valuation, debt/equity split, EBITDA growth, debt paydown, exit valuation, and returns.
The paper LBO is not a shortcut or an approximation. It is a distinct skill. Partners at PE firms use paper LBOs to quickly screen deals before committing analyst time to a full model. Interviewers use them to test whether candidates understand the fundamental mechanics of how an LBO generates returns. If you can execute a paper LBO cleanly and quickly, you demonstrate that you understand the core value creation levers in private equity.
Paper LBO: Six Steps
Step 1: Entry Valuation
Calculate the purchase price. Entry Enterprise Value = LTM EBITDA x Entry Multiple. Example: $100M EBITDA x 8.0x = $800M EV.
Step 2: Debt / Equity Split
Determine how much is debt and how much is equity. Debt = Leverage Multiple x EBITDA. Equity = EV - Debt (ignoring fees for simplicity). Example: 5.0x leverage = $500M debt, $300M equity.
Step 3: Project EBITDA at Exit
Grow EBITDA to the exit year using a simple annual growth rate. Example: $100M growing at 5% for 5 years = $100M x (1.05)^5 = $127.6M.
Step 4: Estimate Debt Paydown
Estimate how much debt is repaid during the hold period using free cash flow. A common shortcut: assume 20-40% of initial debt is repaid, or calculate from annual FCF estimates.
Step 5: Exit Valuation
Calculate the exit enterprise value. Exit EV = Exit EBITDA x Exit Multiple. Subtract remaining debt to get exit equity value. Example: $127.6M x 8.0x = $1,021M EV. Remaining debt = $350M. Equity = $671M.
Step 6: Calculate Returns
MOIC = Exit Equity / Entry Equity. IRR is approximated using the Rule of 72 or standard annualization. Example: $671M / $300M = 2.24x MOIC over 5 years, implying roughly 17-18% IRR.
Step 1: Entry Valuation
Calculate the purchase price. Entry Enterprise Value = LTM EBITDA x Entry Multiple. Example: $100M EBITDA x 8.0x = $800M EV.
Step 2: Debt / Equity Split
Determine how much is debt and how much is equity. Debt = Leverage Multiple x EBITDA. Equity = EV - Debt (ignoring fees for simplicity). Example: 5.0x leverage = $500M debt, $300M equity.
Step 3: Project EBITDA at Exit
Grow EBITDA to the exit year using a simple annual growth rate. Example: $100M growing at 5% for 5 years = $100M x (1.05)^5 = $127.6M.
Step 4: Estimate Debt Paydown
Estimate how much debt is repaid during the hold period using free cash flow. A common shortcut: assume 20-40% of initial debt is repaid, or calculate from annual FCF estimates.
Step 5: Exit Valuation
Calculate the exit enterprise value. Exit EV = Exit EBITDA x Exit Multiple. Subtract remaining debt to get exit equity value. Example: $127.6M x 8.0x = $1,021M EV. Remaining debt = $350M. Equity = $671M.
Step 6: Calculate Returns
MOIC = Exit Equity / Entry Equity. IRR is approximated using the Rule of 72 or standard annualization. Example: $671M / $300M = 2.24x MOIC over 5 years, implying roughly 17-18% IRR.
The Three Return Drivers in an LBO
Every dollar of value created in an LBO comes from exactly three sources:
1. EBITDA Growth. If EBITDA increases during the hold period, the company is worth more at exit (assuming the same multiple). Revenue growth and margin expansion both contribute.
2. Multiple Expansion. If the exit multiple exceeds the entry multiple, the company sells for more per dollar of EBITDA. For example, buying at 8x and selling at 10x creates 2 'turns' of multiple expansion. PE firms target this through business quality improvements, scale, and favorable market timing, but it is the least controllable driver.
3. Debt Paydown. As the company repays acquisition debt from its cash flows, every dollar of debt retired transfers directly to equity value. Even if EBITDA is flat and the multiple is unchanged, debt paydown alone generates a return. In a 5-year hold with 5x initial leverage, paying down 30% of the debt can add 0.3-0.5x to the equity MOIC.
Let's walk through a complete paper LBO. This is the kind of exercise you should be able to do in under 10 minutes.
Given assumptions:
- Target company LTM EBITDA: $100M
- Entry multiple: 8.0x EV/EBITDA
- Leverage: 5.0x EBITDA (all senior debt)
- EBITDA growth: 5% per year
- Hold period: 5 years
- Exit multiple: 8.0x (no multiple expansion)
- Annual free cash flow available for debt paydown: approximately 50% of EBITDA (a simplifying assumption that accounts for taxes, capex, and interest)
Step 1: Entry Valuation
Entry EV = $100M x 8.0x = $800M
Step 2: Debt / Equity Split
Debt = 5.0x x $100M = $500M
Equity Check = $800M - $500M = $300M
Step 3: EBITDA Projection
Year 1: $100M x 1.05 = $105.0M
Year 2: $105.0M x 1.05 = $110.3M
Year 3: $110.3M x 1.05 = $115.8M
Year 4: $115.8M x 1.05 = $121.6M
Year 5: $121.6M x 1.05 = $127.6M
Step 4: Debt Paydown
We assume annual FCF available for debt repayment is roughly 50% of EBITDA. This is a simplification that accounts for cash taxes, capital expenditures, working capital changes, and interest expense.
Year 1 FCF: ~$52.5M
Year 2 FCF: ~$55.1M
Year 3 FCF: ~$57.9M
Year 4 FCF: ~$60.8M
Year 5 FCF: ~$63.8M
Total cumulative debt paydown: ~$290M
Remaining debt at exit: $500M - $290M = $210M
Step 5: Exit Valuation
Exit EV = $127.6M x 8.0x = $1,021M
Exit Equity Value = $1,021M - $210M remaining debt = $811M
Step 6: Returns
MOIC = $811M / $300M = 2.7x
To estimate IRR, use the Rule of 72 shortcut: a 2.7x return over 5 years means money roughly doubled in about 3.5 years, then grew a bit more. A 2.0x in 5 years is approximately 15% IRR. A 3.0x in 5 years is approximately 25% IRR. So 2.7x in 5 years implies an IRR of roughly 21-22%.
The precise IRR (solved analytically) is approximately 22%. For a paper LBO, getting within 1-2 percentage points is sufficient.
IRR Quick Approximation (for Paper LBOs)
This formula gives a quick IRR estimate assuming a single cash inflow at exit. For our example: IRR = 2.7^(1/5) - 1 = 2.7^0.2 - 1. Using the approximation 2.7^0.2 ≈ 1.22, this gives IRR ≈ 22%. This is a simplification because real LBOs have interim cash flows (management fees, dividends), but it is accurate enough for paper LBO purposes. Memorizing a few benchmarks helps: 2.0x in 5 years ≈ 15% IRR, 2.5x in 5 years ≈ 20% IRR, 3.0x in 5 years ≈ 25% IRR.
In this example, the 2.7x MOIC and ~22% IRR come from two drivers: EBITDA growth (5% annual compounding increased EBITDA from $100M to $127.6M, adding $221M to exit EV) and debt paydown ($290M of debt retired, transferred directly to equity value). There was no multiple expansion because we assumed the same 8.0x entry and exit multiple.
The paper LBO is the foundation. Once you can do this in your head, you can layer on complexity: add transaction fees, model different debt tranches with different rates, stress-test with EBITDA declines or multiple compression, and eventually build the full operating model covered in the next three lessons. But every full model is just a more precise version of the six-step framework you just learned.
Quiz: Paper LBO
6 questions · ~3 min