Fitch Ratings has downgraded Thames Water’s holding company, Kemble Water Finance Ltd long-term Issuer Default Rating (IDR) and senior secured debt rating to 'CC' from 'CCC' – two steps above default.

The downgrade follows Kemble's announcement on 28 March 2024 that it will not be able to fulfill its upcoming interest payments or refinance or repay the £190 million loan maturing on 30 April 2024, unless a maturity extension is granted by lenders.

Commenting on the downgrade, the ratings agency said:

“We believe that some form of default is probable and even if lenders agree to amend and extend (A&E) the upcoming loan, it is highly likely that the agreement would constitute a distressed debt exchange (DDE) under our criteria, which would trigger a downgrade of Kemble to 'Restricted Default' (RD) on completion.”

Ratings agency believes further downgrade "has become highly likely" 

According Fitch’s key rating drivers, with Kemble's shareholders not injecting the £500 million of equity into Thames Water Utilities Ltd (TWUL) expected for end-March 2024, and Kemble considering it not possible currently to fulfill upcoming interest payments, the ratings agency believes that a downgrade to RD has become highly likely. Even assuming that lenders would agree to A&E. the £190 million loan due on 30 April 2024, the agreement would probably constitute a DDE under its criteria.

The completion of the DDE would indicate a material deviation from the original contractual terms, typically to the detriment of creditors, under financial distress conditions. The company has appointed an advisor to assist with lender and noteholder engagement.

No Relief from Liquidity Line: Fitch believes Kemble can no longer draw on its £150 million working capital facility for debt service of secured creditors. Fitch also believes that there is a high possibility that lenders of the working capital facility may exercise their right to halt further draws following the public announcement of liquidity constraints.

Limited Liquidity: Fitch is flagging up that TWUL's decision to distribute dividends (paid usually every six months) of GBP37.5 million in October 2023 has been subject to an information request from the UK water regulatory authority (Ofwat). To date, Ofwat has not taken action so far following its information request. Any adverse updates or negative regulatory developments could put additional strain on the already intricate A&E process at Kemble. Kemble's cash balance is estimated at about £20 million as of end-November 2023 while gross debt stands at £1.35 billion.

Lock-up a Key Risk: Fitchexpects increasing risk of a covenant cash-lock up at TWUL for the remainder of AMP7 (the five-year price control period ending March 2025). The risk of documentary cash lock-up is increasing, in Fitch’s view, as the covenant calculation included £500 million and £250 million of additional equity receipts at TWUL in the financial year ending March 2024 (FY24), and FY25, respectively. The first tranche of £500 million was not received before FY24 ended following the standoff between shareholders and Ofwat.

Regulatory Proposition Delays Equity Support: According to Fitch,Ofwat's feedback to TWUL on risk-and-return for AMP8 (the five-year price control period ending March 2030) has triggered a noticeable shift in shareholder engagement. This development has had a specific impact on the timeliness of equity support assumed by management by FYE24. Both the operating company and the shareholders have expressed concerns, indicating that initial feedback (which is not a formal draft determination) on AMP8 does not represent an investible proposition, which in turn has influenced shareholders' decision to not provide timely equity support in FY24.

Opco's Strategy for Cash Preservation: Management continues to invest in capex for FY25 but notes that mitigating actions (deferring or delaying investments) could be taken involve in order to preserve cash. Nonetheless, we believe such actions, while financially prudent, could worsen TWUL's operational and environment performance.

Standalone Assessment under PSL: Fitch rates Kemble on a standalone basis using the stronger subsidiary/weaker parent approach under its Parent and Subsidiary Linkage (PSL) Rating Criteria. This assessment reflects 'insulated' legal ring-fencing as underlined by a well-defined contractual framework, and tight financial controls imposed by Ofwat and designed to support TWUL's financial profile.

Fitch says it views access and control as overall 'porous' as TWUL operates with separate cash management and a mixture of external and intercompany funding.