Paper LBO Interview: Step-by-Step Framework With Worked Example

Why PE Firms Test Paper LBOs

A paper LBO is not about building a spreadsheet. It is about demonstrating that you can think like a private equity investor — quickly estimating whether a deal generates acceptable returns using mental arithmetic and a structured framework.

Interviewers are testing three things: can you structure the problem, can you do rough maths under pressure, and do you understand what drives returns in a leveraged buyout.

The Four-Step Framework

Step 1: Entry

Start with the company's EBITDA and the entry multiple. Multiply to get enterprise value. Then split into debt and equity based on the leverage ratio.

Example: Company has £100M EBITDA. Entry at 8x. EV = £800M. Debt at 60% = £480M. Equity at 40% = £320M.

Step 2: Hold Period

Project EBITDA growth over the hold period (typically 5 years). A simple compound growth assumption works.

Example: 5% annual EBITDA growth over 5 years. Exit EBITDA = £100M × (1.05)^5 = £127.6M, which rounds to approximately £128M.

Also estimate how much debt is paid down from free cash flow during the hold.

Step 3: Exit

Apply an exit multiple to the projected EBITDA. In a base case, assume the same multiple as entry (no multiple expansion). Calculate exit EV and subtract remaining debt to get exit equity.

Example: Exit at 8x on £128M EBITDA = £1,024M EV. Assume £80M of debt paid down, so remaining debt = £400M. Exit equity = £1,024M - £400M = £624M.

Step 4: Returns

MOIC = Exit Equity / Entry Equity. IRR is approximated from MOIC and hold period.

Example: MOIC = £624M / £320M = 1.95x. For 5 years, use the approximation: IRR ≈ (MOIC)^(1/5) - 1 ≈ 14%. This is below the 20% target — the deal does not work at these assumptions.

IRR Approximation Shortcuts

Memorise these anchor points:

2x in 5 years = ~15% IRR
3x in 5 years = ~25% IRR
2x in 3 years = ~26% IRR
3x in 3 years = ~44% IRR

The Rule of 72 also helps: divide 72 by the IRR to get the doubling time. 72 / 15 ≈ 5 years to double your money.

What Drives Returns in an LBO

Returns come from three sources:

EBITDA growth — organic revenue growth or margin improvement increases exit enterprise value
Multiple expansion — exiting at a higher multiple than entry (never assume this in a base case)
Leverage (debt paydown and cash generation) — the company generates net income over the hold period. That cash either sits on the balance sheet or is used to repay debt. Either way, equity value increases because the cash was generated from operations and accrues to shareholders. A common misconception is that debt repayment itself creates equity value. It does not. Repaying £50M of debt with £50M of cash is a zero-sum balance sheet move. The equity value increase comes from the underlying cash generation that made the repayment possible.

Why leverage amplifies returns If a company with £100M EV is bought with £60M debt and £40M equity, and it generates £10M of net income per year for 5 years, the equity value increases by £50M. That is a 125% return on the £40M of equity invested, even if EV never changes. The same company bought with 100% equity (£100M) and generating the same £50M of cash would return only 50%. The leverage did not create the cash. It amplified the return on the equity cheque by reducing the denominator.

Common Mistakes

Assuming multiple expansion in the base case — interviewers will challenge this immediately
Forgetting to subtract remaining debt from exit EV — you are calculating equity returns, not enterprise returns
Using overly optimistic growth rates without justifying them
Not knowing the IRR shortcuts — fumbling with mental maths wastes time and confidence
Losing track of the debt schedule — if the company has two debt tranches (e.g. term loan at 5% and senior notes at 10%), track them separately. Interest expense changes each year as principal is repaid, which affects FCF, which affects the next year's repayment. Write this down; do not try to hold it in your head.

Rounding compounds Round aggressively to units of 5 or 10. But be consistent in which direction you round. If you round revenue up by £5M in Year 1, that error compounds through EBITDA, FCF, and debt paydown for every subsequent year. Small rounding in Year 1 can produce a £20-30M discrepancy by Year 5. The interviewer knows this and will not penalise reasonable approximation, but inconsistent rounding that makes the deal look better than it is will be caught.

Advanced: Back-Solving for Required EBITDA Growth

PE interviewers sometimes reverse the question: "Given a target IRR, what EBITDA growth do you need?" This tests whether you can work the framework backwards.

Worked example Buy a company at £100M EBITDA, 10x entry multiple (£1,000M EV). 50% debt (£500M), 50% equity (£500M). Exit at 10x in 5 years. Repay 50% of debt. Target: 20% IRR.

Step 1: 20% IRR over 5 years ≈ 2.5x MOIC. Exit equity needed = £500M × 2.5 = £1,250M.

Step 2: Remaining debt at exit = £250M. Exit EV = £1,250M + £250M = £1,500M.

Step 3: Exit EBITDA = £1,500M ÷ 10x = £150M. Growth from £100M to £150M = 50% total, or roughly 8-9% per year.

Answer: "The company needs to grow EBITDA from £100M to £150M over 5 years, which is about 8.5% annually. That is achievable through a combination of mid-single-digit revenue growth and modest margin expansion."

Advanced: IPO Exit With Staggered Selling

Most paper LBOs assume a clean trade sale. PE firms sometimes ask about an IPO exit where the sponsor sells its stake over multiple years (due to lockup periods).

The key adjustment: calculate a weighted average year to exit instead of a single exit year.

Example: Sponsor sells one-third of its stake in Year 3, one-third in Year 4, and one-third in Year 5. The weighted average exit year = (1/3 × 3) + (1/3 × 4) + (1/3 × 5) = 4 years. Use 4 years as the holding period for your IRR approximation, not 3 or 5.

Advanced: Back-Solving for Maximum Entry Price

Another common variant: given a target MOIC and exit assumptions, what is the maximum price the PE firm can pay? This tests whether you can work the framework in reverse from returns to entry.

Worked example Target: 3.0x MOIC over 5 years. EBITDA is £250M (flat). Exit at 6x. Debt: £750M at 10% interest. Capex = D&A = £35M. Tax rate: 25%. Working capital provides £6M per year.

Step 1 — Annual cash flow: EBITDA £250M - D&A £35M - Interest £75M = £140M pre-tax. Tax at 25% = £35M. Net income = £105M. Add back D&A £35M, add WC £6M, subtract capex £35M. Cash generated = £111M per year, or roughly £555M over 5 years.

Step 2 — Exit equity: Exit EV = £250M × 6x = £1,500M. Subtract debt £750M. Add accumulated cash £555M. Exit equity = £1,305M.

Step 3 — Back-solve for entry equity: £1,305M ÷ 3.0x = £435M maximum equity cheque.

Step 4 — Maximum entry price: £435M equity + £750M debt = £1,185M. Entry multiple = £1,185M ÷ £250M = 4.7x.

Answer: "The maximum entry price is approximately £1.2B, or 4.7x EBITDA, to achieve a 3.0x return over 5 years."

Take Your Preparation Further

For a complete PE interview preparation including paper LBOs, integrated models, deal experience frameworks, and investment memo structure, see the PE Interview Masterclass. Practice building full LBO models with our LBO Model Template.

Ready for personalised feedback? Book a 1-on-1 mentoring session with an experienced IB/PE professional.

Paper LBO: How to Solve One in a PE Interview (Step-by-Step)