Paper LBO Step by Step, with a Worked Example

What is a paper LBO?

A paper LBO is a simplified version of an LBO model (leveraged buyout, the purchase of a company financed largely with debt), done by hand or in your head. It answers a single question: if a fund buys this company at this price, with this level of debt, and sells it in five years, what return does it earn?

The return is read through two measures:

• MOIC (multiple on invested capital): what the fund gets back at exit divided by what it invested. A MOIC of 2.5x means that €60m has become €150m.
• IRR (internal rate of return): the equivalent annual return, which takes the holding period into account. Doubling your money in three years is better than doubling it in seven.

The paper LBO is used in two situations. In a private equity or investment banking interview, it tests whether the candidate understands how an LBO works without a spreadsheet. At the start of a deal, it tells an investment team whether a target is worth building the full model for.

The paper LBO method in six steps

A paper LBO always follows the same order:

1. The entry price: the target's EBITDA multiplied by the entry multiple. This gives the enterprise value (EV), that is, the price of the business, debt included.
2. The financing: the debt raised (expressed as a multiple of EBITDA) and the fund's equity contribution, which fills the gap.
3. The EBITDA projection over the holding period, usually five years.
4. The free cash flow of each year, which is used to repay the debt.
5. The exit price: the final year's EBITDA multiplied by the exit multiple, less the remaining debt.
6. The return: MOIC, then IRR.

Paper LBO worked example

Take a fictional industrial company, which we will call Target Ltd. All the assumptions below are for illustration.

Assumption	Value
Year 0 revenue	€100m
EBITDA margin	20% (constant)
Revenue growth	5% a year
Entry and exit multiple	8.0x EBITDA
Acquisition debt	5.0x EBITDA, at an interest rate of 7%
Capital expenditure	3% of revenue, equal to depreciation
Working capital requirement	10% of the increase in revenue
Corporation tax	25%
Holding period	5 years

To keep things readable, we ignore transaction fees and the target's opening cash.

Steps 1 and 2: entry price and financing

Year 0 EBITDA is 100 × 20% = €20m. At 8.0x, the enterprise value is €160m.

The debt is 5.0 × 20 = €100m. The fund provides the rest as equity: 160 − 100 = €60m. Debt funds 62.5% of the price, which is within the usual range for an LBO.

Steps 3 and 4: EBITDA and cash flow

Free cash flow is calculated each year as follows:

Cash flow = EBITDA − capex − increase in working capital − tax − interest

Tax is charged on profit before tax: EBITDA, less depreciation, less interest. Interest is calculated on the debt at the start of the year. All of the cash flow is used to repay debt (known as a cash sweep).

Year	Revenue	EBITDA	Capex	Increase in working capital	Tax	Interest	Free cash flow	Debt at year end
1	105.0	21.0	3.2	0.5	2.7	7.0	7.6	92.4
2	110.3	22.1	3.3	0.5	3.1	6.5	8.7	83.7
3	115.8	23.2	3.5	0.6	3.5	5.9	9.8	73.9
4	121.6	24.3	3.6	0.6	3.9	5.2	11.0	62.8
5	127.6	25.5	3.8	0.6	4.3	4.4	12.4	50.5

In €m, figures rounded to one decimal place.

The cash flow rises every year for two reasons: EBITDA grows, and interest falls as the debt shrinks. Over five years the company repays €49.5m, half of its debt.

Step 5: the exit price

At exit, EBITDA reaches €25.5m. At the same 8.0x multiple, the enterprise value is €204.2m. Deduct the remaining debt of €50.5m and the equity is worth €153.7m.

Step 6: MOIC and IRR

• MOIC = 153.7 ÷ 60 = 2.56x.
• IRR = 2.56^(1/5) − 1 = 20.7% a year.

The deal clears the 20% IRR hurdle that many funds set for a mid-market LBO. That threshold varies from fund to fund and from one period to another.

Where the value creation comes from

The fund's gain, 153.7 − 60 = €93.7m, breaks down into three sources:

Source	Calculation	Gain
EBITDA growth	(25.53 − 20.0) × 8.0	€44.2m
Deleveraging	100 − 50.5	€49.5m
Change in multiple	8.0 − 8.0 = 0	0
Total		€93.7m

This breakdown is the question that almost always follows a paper LBO in an interview. Here, half of the return comes from repaying debt, which is typical of a mature company with moderate growth. A fund that relies mainly on a higher exit multiple is taking a risk it does not control: the multiple depends on the market at the time of sale.

To judge whether 8.0x is a reasonable price for the industry, our article on choosing an EBITDA multiple explains how to read listed companies and comparable transactions.

Mental-maths shortcuts

In an interview, nobody expects a fifth root to the decimal place. Remember these correspondences between MOIC and IRR:

MOIC	IRR over 3 years	IRR over 5 years
1.5x	14.5%	8.4%
2.0x	26.0%	14.9%
2.5x	35.7%	20.1%
3.0x	44.2%	24.6%

Two benchmarks to know by heart: doubling in five years is about 15% a year; tripling in five years is about 25%. With a MOIC of 2.56x over five years, you can say "a little over 20%" without a calculator.

For deleveraging, an approximation is often enough: estimate an average annual cash flow (here around €10m) and multiply by the number of years. 10 × 5 = €50m repaid, very close to the €49.5m in the table.

Sensitivity to the exit multiple

The exit multiple is the assumption that matters most. All other things being equal:

Exit multiple	Exit EV	Equity	MOIC	IRR
7.0x	€178.7m	€128.2m	2.14x	16.4%
8.0x	€204.2m	€153.7m	2.56x	20.7%
9.0x	€229.7m	€179.3m	2.99x	24.5%

One turn of multiple moves the IRR by about 4 points. That is why the prudent assumption is to exit at the entry multiple, or even below it.

Common mistakes

1. Calculating IRR by dividing the gain by the number of years. A MOIC of 2.56x over five years is not 31% a year (156% ÷ 5) but 20.7%, because returns compound.
2. Forgetting the remaining debt at exit. Enterprise value belongs first to the lenders. Equity receives only the balance.
3. Calculating tax before interest. Interest is deductible: forgetting it inflates the tax charge and understates deleveraging.
4. Assuming a higher exit multiple without justifying it. It flatters the IRR without saying anything about the quality of the investment.
5. Ignoring fees. In a real deal, transaction and financing fees (often a few points of the price) increase the equity contribution and reduce the IRR.

From the paper LBO to the full LBO model

The paper LBO gives an order of magnitude. The full LBO model adds what it simplifies: several debt tranches with their own rates and repayment schedules, fees, detailed working capital, early repayment clauses and cross sensitivities. To check an IRR from irregular cash flows, the IRR calculator does the exact calculation.