Thames Water Utilities Ltd.
Thames Water’s Non Ring-Fenced Debt Vulnerable to Impairment in Special Administration; Enforcement of Security Challenging Without Ofwat’s Consent
Fri 06/30/2023 10:08 AM
Relevant Documents:
H1 Report
H1 Release
H1 Investor Report
Annual Report 21/22
TWUL License
Prospectus Kemble Water Finance
Prospectus Thames Water (Kemble) Finance plc
Prospectus supplement Thames Water Utilities Finance plc
If Thames Water is placed into a special administration, liabilities that sit outside the reach of Thames Water Utilities Ltd., or TWUL, will be particularly vulnerable to impairment, according to Reorg’s analysis. Liabilities out of TWUL’s reach are those that are neither issued nor guaranteed by TWUL, or whose guarantees cannot be enforced over TWUL.
However, even secured creditors will find it difficult if not impossible to enforce security over the core operating assets of the regulated business without the consent of U.K. water regulator Ofwat and/or the Secretary of State.
TWUL is the largest regulated water company in the country and provides water and wastewater services to 25% of the U.K.’s population. As such, in a special administration the key objective is to ensure continuity of service to consumers, ahead of the interests of creditors or shareholders.
The special administrator is tasked with pursuing a sale or restructuring of the business with this overriding statutory objective in mind. Accordingly, the Special Administration Regime, or SAR, suspends the normal provisions of the Insolvency Act 1986 and grants the special administrator powers to disapply or amend legislation governing schemes of arrangement, restructuring plans and Company Voluntary Arrangements in pursuit of this goal.
As of Sept. 30, 2022, Thames Water’s net debt stood at £15.8 billion according to Reorg’s capital structure, including the debt at the holdco and the shareholder loan. The group’s capital structure is split between a ring-fenced part comprising the regulated opco, its holding company, and its financing company, (see diagram below) and debt issued by entities outside the ring-fenced structure as part of a whole-of-business securitization. The debt outside of the ring-fenced structure does not have any assets as security and is entirely reliant on dividends from the holding company.
In December, Ofwat began close engagement with Thames Water and several other water companies with the highest leverage in the sector with the aim of improving their financial resilience. Ofwat has instructed Thames Water to raise £1 billion of equity from its shareholders to support the delivery of its revised turnaround plan announced in June 2022. This is in addition to £500 million of equity provided in March this year.
The metric used by the regulator for monitoring leverage is a gearing ratio calculated by dividing the group’s net debt by its regulatory capital value, or RCV. RCV represents the value of Thames Water’s assets as agreed with Ofwat. As of Sept. 30, 2022, the group’s RCV was £17.867 billion compared with £13.776 billion of net debt, which leads to a gearing ratio of 80%, according to the covenant definition. Taking into account the financing outside of the securitization group, the gearing rises to 87% based on net debt of £15.547 billion, which excludes shareholder loans. This implies an equity value of £2.319 billion. If the group’s capital structure is unsustainable, as a minimum, the company may require a haircut on its bonds to reduce the regulatory gearing ratio to the notional 60% set by Ofwat.
Following the unexpected departure of the group's CEO Sarah Bentley this week, bonds issued by the group dropped to the 50s, as reported.
Special Administration
If Thames Water is unable to raise the required funds, Ofwat, at the direction of the Secretary of State, could apply to place the group into special administration. The applicable administration regime SAR is under the Water Industry (Special Administration) Rules 2009.
The government insists that Thames Water’s funding needs are “a matter for the company and its shareholders.” But it added that it is prepared for a range of scenarios across regulated industries.
The purpose of the SAR is not to keep a company in business but rather to ensure that the provision of services to customers is maintained.
The grounds for filing a petition are set out section 24(2) of the Water Industry Act 1991 and include a breach of a principal duty (that is a statutory duty imposed on a licensed water company) or an inability to pay debts as they fall due, a cash flow insolvency or a balance sheet insolvency i.e. the value of the company’s assets is less than the amount of its liabilities.
During a special administration the Secretary of State has the power (under s153 of the Water Act 1991), with the consent of HM Treasury, to directly fund the company and grant indemnities to cover liability and loss giving the SAR the character of a quasi nationalization. However, the SAR itself does not, of itself, transfer ownership of the group to the state.
Unlike energy utilities, water companies operate as regional monopolies, which means their customers cannot be switched to a competitor. Accordingly, the only tested solution to financial distress is the transfer of the regulated water company to a new owner. In 2001, before the introduction of the Water SAR, Wessex Water was able to continue operating while it was transferred to new owners despite the collapse of its owner, Enron.
Any sale would be implemented using a court-approved transfer scheme, similar to that used by special administrators to transfer Bulb Energy’s assets to Octopus Energy in 2022.
However, in 2010 an amendment to the 1991 Act imposed a duty on a special administrator to seek a rescue of a water company as a going concern rather than simply transferring the ring-fenced business to a new owner. For the purposes of a rescue, a special administrator may propose a Company Voluntary Arrangement, a Part 26 Scheme of Arrangement, or a Part 26A restructuring plan. These restructuring tools could be used to reduce the group gearing to a level acceptable to Ofwat or to a greater extent.
If the special administrator considers that a rescue is “not likely to be possible” or that a transfer to a new owner is more likely to secure more effective performance of its duties as a licensed water supplier, a transfer scheme should be pursued.
The aim of a transfer scheme is to transfer as a going concern only that part of the company that is necessary to ensure the continued functions of its duties as a licensed water supplier. In the case of Thames Water, that is the regulated opco Thames Water Utilities Ltd. In such a scenario the special administrator could sell only TWUL, or just the companies in the restricted group, leaving the other debt issuers in the group stranded.
Whether the special administrator decides to restructure the group’s debt or hive off the regulated opco, the ultimate statutory purpose of the SAR must be borne in mind ahead of creditor and shareholder interests. As the TWUL notes prospectus explains:
To this end, the Secretary of State also has sweeping powers to use a statutory instrument to modify a provision of the Insolvency Act 1986 or the Companies Act 2006 in respect of a CVA, scheme or restructuring plan to support the policy objectives of the special administration.
If the special administrator decides to sell the business, then the usual insolvency rules do not apply. A secured creditor is entitled to proceeds arising from “the best price which is reasonably available on a sale which is consistent with the purposes of the Special Administration Order” rather than the best available open market price. Moreover, a special administrator is not permitted to accept an offer to purchase the assets on a break-up basis in circumstances where the purchaser would be unable to properly carry out the relevant functions of a regulated water company.
Unenforceable Security?
Ofwat has said that despite press commentary on Thames Water, the group has “strong liquidity.” However, in the event that the group failed to pay interest or principal on its debt, it is worth considering how easily creditors could enforce their security.
Under the terms of the Thames Water Utilities Finance plc, or TWUF, notes issued in 2007, secured creditors benefit from a full security package over the rights and assets of the three entities in the existing group.
With respect to TWUL, the security and cross guarantees that have been provided are granted only to the extent permitted by the Water Industry Act 1991 and the TWUL license. As a result, this offers limited protection to secured creditors.
For example, enforcement over the secured assets at TWUL is prohibited unless 14 days’ prior notice to Ofwat or the Secretary of State has been given. This would allow Ofwat/ the Secretary of State time to petition for the appointment of a special administrator since the group is arguably cash flow insolvent, and so block an enforcement without court permission. Once the order is in force, no steps may be taken to enforce any security over the property of TWUL except with the consent of the special administrator or the leave of the Court. In addition, any subsequent planned disposal to a third-party purchaser of the shares in TWUL held by TWUH would involve consultation with Ofwat.
As a result, notwithstanding the security provided by the TWU Financing Group, both structurally and through the protections enshrined in the Water Industry Act and the TWUL license, TWUL and its assets are effectively ringfenced.
An overview of Thames Water’s debt structure is below:
Background/ Financial Performance
The funding need arises from the group's capital intensive turnaround plan to dramatically improve the ever failing water network which has led to a record number of leakages and the group indicating that it will struggle to meet its 2022/2023 targets, according to the Telegraph.
Additionally, the group was hit by rising energy costs as well as rising interest costs.
Largely driven by inflation indexation of £1.833 billion, the RCV, which represents the value of Thames water assets as agreed with Ofwat for the 2022/ 2023 period, is £18.945 billion.
Thames Water said it continues to work constructively with its shareholders regarding further equity funding expected to be required to support its turnaround and investment plans.
Thames Water’s main shareholders are Ontario Municipal Employees Retirement System, or Omers, (31.77%), Universities Superannuation Scheme (19.71%), Infinity Investments (9%), British Columbia Investment Management Corp. (8.7%), Hermes GPE (8.7%), China Investment Corp. (5.4%), Aquila GP (5%), Stichting Pensioenfonds Zorg en Welzijn (2.2%).
Thames Water’s biggest shareholder Omers is reluctant to inject fresh capital into the business after a series of poor investments in the U.K., according to the Telegraph, Another shareholder, the Universities Superannuation Scheme, is willing to inject fresh money. Whilst transactions in the space are rare it is worth mentioning Macquarie purchased a 71% stake in Yorkshire Water in 2021 for approximately £1 billion, compared with the implied real equity value of £975 million according to Reorgs‘ estimates.
Thames Water has been working with Rothschild and law firm Slaughter & May since March to explore financing options for the company.
In March, the company received £500 million of new equity funding from its shareholders to support the delivery of its revised turnaround plan announced in June 2022. However, the company had requested an additional £1 billion of equity funding to deliver a revised business plan for the regulatory period ending March 2025, in May. At the same time Ofwat has conditionally granted it £300 million to enhance the performance of its London water network, with an additional £400 million committed by shareholders.
According to Thames Water, the £700 million will fund work to replace 112 km of water distribution mains and seven large trunk mains across London.
In June 2022, the board and Kemble shareholders approved a revised £11.5 billion business plan for the current regulatory period ending March 31, 2025, according to the TWUF prospectus. The business plan represents a £2 billion increase in expenditure, compared with the £9.6 billion agreed in TWUL’s final determination for April 1, 2020, to March 31, 2025. The revised business plan is designed to enable TWUL to improve operational performance, deliver its regulatory obligations, increase resilience and deliver better outcomes for customers, communities and the environment.
The company said it had a strong liquidity as of March 31, including £4.4 billion cash and committed funding.
Reorg understands that historically, PwC, the external auditor for Thames Water, delivers its audited accounts in early July. Under the terms of the TWUL license, the board will also have to certify, by delivering a ‘ring-fencing certificate’ to Ofwat that, amongst other things, in its opinion TWUL will have sufficient financial resources, management resources and systems of planning and internal control to carry out its regulated activities for at least the following 12 months.
A summary of key financials is below:
Ofwat has supervised the English and Welsh framework since the sector’s privatization in the late 1980s. It resets its guidelines including its price review process every five years, with the next one starting in April 2025.
--Connor Lovell, Celine Buttanshaw, Wayne Jambawo
H1 Report
H1 Release
H1 Investor Report
Annual Report 21/22
TWUL License
Prospectus Kemble Water Finance
Prospectus Thames Water (Kemble) Finance plc
Prospectus supplement Thames Water Utilities Finance plc
If Thames Water is placed into a special administration, liabilities that sit outside the reach of Thames Water Utilities Ltd., or TWUL, will be particularly vulnerable to impairment, according to Reorg’s analysis. Liabilities out of TWUL’s reach are those that are neither issued nor guaranteed by TWUL, or whose guarantees cannot be enforced over TWUL.
However, even secured creditors will find it difficult if not impossible to enforce security over the core operating assets of the regulated business without the consent of U.K. water regulator Ofwat and/or the Secretary of State.
TWUL is the largest regulated water company in the country and provides water and wastewater services to 25% of the U.K.’s population. As such, in a special administration the key objective is to ensure continuity of service to consumers, ahead of the interests of creditors or shareholders.
The special administrator is tasked with pursuing a sale or restructuring of the business with this overriding statutory objective in mind. Accordingly, the Special Administration Regime, or SAR, suspends the normal provisions of the Insolvency Act 1986 and grants the special administrator powers to disapply or amend legislation governing schemes of arrangement, restructuring plans and Company Voluntary Arrangements in pursuit of this goal.
As of Sept. 30, 2022, Thames Water’s net debt stood at £15.8 billion according to Reorg’s capital structure, including the debt at the holdco and the shareholder loan. The group’s capital structure is split between a ring-fenced part comprising the regulated opco, its holding company, and its financing company, (see diagram below) and debt issued by entities outside the ring-fenced structure as part of a whole-of-business securitization. The debt outside of the ring-fenced structure does not have any assets as security and is entirely reliant on dividends from the holding company.
In December, Ofwat began close engagement with Thames Water and several other water companies with the highest leverage in the sector with the aim of improving their financial resilience. Ofwat has instructed Thames Water to raise £1 billion of equity from its shareholders to support the delivery of its revised turnaround plan announced in June 2022. This is in addition to £500 million of equity provided in March this year.
The metric used by the regulator for monitoring leverage is a gearing ratio calculated by dividing the group’s net debt by its regulatory capital value, or RCV. RCV represents the value of Thames Water’s assets as agreed with Ofwat. As of Sept. 30, 2022, the group’s RCV was £17.867 billion compared with £13.776 billion of net debt, which leads to a gearing ratio of 80%, according to the covenant definition. Taking into account the financing outside of the securitization group, the gearing rises to 87% based on net debt of £15.547 billion, which excludes shareholder loans. This implies an equity value of £2.319 billion. If the group’s capital structure is unsustainable, as a minimum, the company may require a haircut on its bonds to reduce the regulatory gearing ratio to the notional 60% set by Ofwat.
Following the unexpected departure of the group's CEO Sarah Bentley this week, bonds issued by the group dropped to the 50s, as reported.
Special Administration
If Thames Water is unable to raise the required funds, Ofwat, at the direction of the Secretary of State, could apply to place the group into special administration. The applicable administration regime SAR is under the Water Industry (Special Administration) Rules 2009.
The government insists that Thames Water’s funding needs are “a matter for the company and its shareholders.” But it added that it is prepared for a range of scenarios across regulated industries.
The purpose of the SAR is not to keep a company in business but rather to ensure that the provision of services to customers is maintained.
The grounds for filing a petition are set out section 24(2) of the Water Industry Act 1991 and include a breach of a principal duty (that is a statutory duty imposed on a licensed water company) or an inability to pay debts as they fall due, a cash flow insolvency or a balance sheet insolvency i.e. the value of the company’s assets is less than the amount of its liabilities.
During a special administration the Secretary of State has the power (under s153 of the Water Act 1991), with the consent of HM Treasury, to directly fund the company and grant indemnities to cover liability and loss giving the SAR the character of a quasi nationalization. However, the SAR itself does not, of itself, transfer ownership of the group to the state.
Unlike energy utilities, water companies operate as regional monopolies, which means their customers cannot be switched to a competitor. Accordingly, the only tested solution to financial distress is the transfer of the regulated water company to a new owner. In 2001, before the introduction of the Water SAR, Wessex Water was able to continue operating while it was transferred to new owners despite the collapse of its owner, Enron.
Any sale would be implemented using a court-approved transfer scheme, similar to that used by special administrators to transfer Bulb Energy’s assets to Octopus Energy in 2022.
However, in 2010 an amendment to the 1991 Act imposed a duty on a special administrator to seek a rescue of a water company as a going concern rather than simply transferring the ring-fenced business to a new owner. For the purposes of a rescue, a special administrator may propose a Company Voluntary Arrangement, a Part 26 Scheme of Arrangement, or a Part 26A restructuring plan. These restructuring tools could be used to reduce the group gearing to a level acceptable to Ofwat or to a greater extent.
If the special administrator considers that a rescue is “not likely to be possible” or that a transfer to a new owner is more likely to secure more effective performance of its duties as a licensed water supplier, a transfer scheme should be pursued.
The aim of a transfer scheme is to transfer as a going concern only that part of the company that is necessary to ensure the continued functions of its duties as a licensed water supplier. In the case of Thames Water, that is the regulated opco Thames Water Utilities Ltd. In such a scenario the special administrator could sell only TWUL, or just the companies in the restricted group, leaving the other debt issuers in the group stranded.
Whether the special administrator decides to restructure the group’s debt or hive off the regulated opco, the ultimate statutory purpose of the SAR must be borne in mind ahead of creditor and shareholder interests. As the TWUL notes prospectus explains:
“During the period of the [Special Administration] order, the Regulated Company is managed for the achievement of the purposes of the order and in a manner which protects the respective interests of members and creditors. However, the effect of other provisions of the Water Industry Act [see below] is ultimately to subordinate members’ and creditors’ rights to the achievement of the purposes of the Special Administration Order.”
To this end, the Secretary of State also has sweeping powers to use a statutory instrument to modify a provision of the Insolvency Act 1986 or the Companies Act 2006 in respect of a CVA, scheme or restructuring plan to support the policy objectives of the special administration.
If the special administrator decides to sell the business, then the usual insolvency rules do not apply. A secured creditor is entitled to proceeds arising from “the best price which is reasonably available on a sale which is consistent with the purposes of the Special Administration Order” rather than the best available open market price. Moreover, a special administrator is not permitted to accept an offer to purchase the assets on a break-up basis in circumstances where the purchaser would be unable to properly carry out the relevant functions of a regulated water company.
Unenforceable Security?
Ofwat has said that despite press commentary on Thames Water, the group has “strong liquidity.” However, in the event that the group failed to pay interest or principal on its debt, it is worth considering how easily creditors could enforce their security.
Under the terms of the Thames Water Utilities Finance plc, or TWUF, notes issued in 2007, secured creditors benefit from a full security package over the rights and assets of the three entities in the existing group.
With respect to TWUL, the security and cross guarantees that have been provided are granted only to the extent permitted by the Water Industry Act 1991 and the TWUL license. As a result, this offers limited protection to secured creditors.
For example, enforcement over the secured assets at TWUL is prohibited unless 14 days’ prior notice to Ofwat or the Secretary of State has been given. This would allow Ofwat/ the Secretary of State time to petition for the appointment of a special administrator since the group is arguably cash flow insolvent, and so block an enforcement without court permission. Once the order is in force, no steps may be taken to enforce any security over the property of TWUL except with the consent of the special administrator or the leave of the Court. In addition, any subsequent planned disposal to a third-party purchaser of the shares in TWUL held by TWUH would involve consultation with Ofwat.
As a result, notwithstanding the security provided by the TWU Financing Group, both structurally and through the protections enshrined in the Water Industry Act and the TWUL license, TWUL and its assets are effectively ringfenced.
An overview of Thames Water’s debt structure is below:
Background/ Financial Performance
The funding need arises from the group's capital intensive turnaround plan to dramatically improve the ever failing water network which has led to a record number of leakages and the group indicating that it will struggle to meet its 2022/2023 targets, according to the Telegraph.
Additionally, the group was hit by rising energy costs as well as rising interest costs.
Largely driven by inflation indexation of £1.833 billion, the RCV, which represents the value of Thames water assets as agreed with Ofwat for the 2022/ 2023 period, is £18.945 billion.
Thames Water said it continues to work constructively with its shareholders regarding further equity funding expected to be required to support its turnaround and investment plans.
Thames Water’s main shareholders are Ontario Municipal Employees Retirement System, or Omers, (31.77%), Universities Superannuation Scheme (19.71%), Infinity Investments (9%), British Columbia Investment Management Corp. (8.7%), Hermes GPE (8.7%), China Investment Corp. (5.4%), Aquila GP (5%), Stichting Pensioenfonds Zorg en Welzijn (2.2%).
Thames Water’s biggest shareholder Omers is reluctant to inject fresh capital into the business after a series of poor investments in the U.K., according to the Telegraph, Another shareholder, the Universities Superannuation Scheme, is willing to inject fresh money. Whilst transactions in the space are rare it is worth mentioning Macquarie purchased a 71% stake in Yorkshire Water in 2021 for approximately £1 billion, compared with the implied real equity value of £975 million according to Reorgs‘ estimates.
Thames Water has been working with Rothschild and law firm Slaughter & May since March to explore financing options for the company.
In March, the company received £500 million of new equity funding from its shareholders to support the delivery of its revised turnaround plan announced in June 2022. However, the company had requested an additional £1 billion of equity funding to deliver a revised business plan for the regulatory period ending March 2025, in May. At the same time Ofwat has conditionally granted it £300 million to enhance the performance of its London water network, with an additional £400 million committed by shareholders.
According to Thames Water, the £700 million will fund work to replace 112 km of water distribution mains and seven large trunk mains across London.
In June 2022, the board and Kemble shareholders approved a revised £11.5 billion business plan for the current regulatory period ending March 31, 2025, according to the TWUF prospectus. The business plan represents a £2 billion increase in expenditure, compared with the £9.6 billion agreed in TWUL’s final determination for April 1, 2020, to March 31, 2025. The revised business plan is designed to enable TWUL to improve operational performance, deliver its regulatory obligations, increase resilience and deliver better outcomes for customers, communities and the environment.
The company said it had a strong liquidity as of March 31, including £4.4 billion cash and committed funding.
Reorg understands that historically, PwC, the external auditor for Thames Water, delivers its audited accounts in early July. Under the terms of the TWUL license, the board will also have to certify, by delivering a ‘ring-fencing certificate’ to Ofwat that, amongst other things, in its opinion TWUL will have sufficient financial resources, management resources and systems of planning and internal control to carry out its regulated activities for at least the following 12 months.
A summary of key financials is below:
Ofwat has supervised the English and Welsh framework since the sector’s privatization in the late 1980s. It resets its guidelines including its price review process every five years, with the next one starting in April 2025.
--Connor Lovell, Celine Buttanshaw, Wayne Jambawo
This article is an example of the content you may receive if you subscribe to a product of Reorg Research, Inc. or one of its affiliates (collectively, “Reorg”). The information contained herein should not be construed as legal, investment, accounting or other professional services advice on any subject. Reorg, its affiliates, officers, directors, partners and employees expressly disclaim all liability in respect to actions taken or not taken based on any or all the contents of this publication. Copyright © 2024 Reorg Research, Inc. All rights reserved.