Fitch Downgrades Avon Energy Partners Holding; Remains On Rating Watch Evolving

Business Wire, Feb 24, 2003

Business Editors

LONDON--(BUSINESS WIRE)--Feb. 24, 2003

Fitch Ratings, the international rating agency, has lowered the senior unsecured and short-term ratings of Avon Energy Partners Holding (AEPH) to 'BB-' and 'B', respectively. The ratings remain on Rating Watch Evolving. AEPH is the ultimate group holding company of Midlands Electricity plc (ME) and Aquila Power Networks (APN). The ratings of ME and APN remain unchanged at 'BBB-/F3' and 'BBB /F2' respectively. These ratings also remain on Rating Watch Evolving.

The rating action reflects the impaired ability of AEPH to service its debt obligations within the group given the cash transfer restrictions imposed by Ofgem upon APN, the regulated entity, (which will now apply also to ordinary dividends) and the highly speculative nature of cash flow dividends from other unregulated businesses. The sale process is now in the sixth month of negotiation and, although Fitch understands that there might be at least one offer which would cover the total outstanding debt within the group, additional liquidity pressure on the U.S. parent Aquila Inc. (downgraded today to 'B ', remaining on Rating Watch Negative, see separate press release available on the Fitch Ratings web site at 'www.fitchratings.com') might precipitate a conclusion of the sale process under which the interests of AEPH bondholders - facing greatest subordination relative to the operational assets of APN - would be at increased risk.

In August 2002 Fitch put Avon Energy, Midlands & Aquila Power ratings on Rating Watch Evolving following the announcement by Aquila Inc. that it would dispose of its 79% share in Avon Energy Partners Holding, the UK holding company for Midlands Electricity plc (ME), which in turn owns UK electricity distributor Aquila Power Networks (APN). The Rating Watch Evolving was predicated upon the lack of visibility on both capital structure of the group and the credit profile of a future buyer.

In November 2002, majority parent Aquila Inc. was downgraded to 'BB', and remained on Rating Watch Negative. This would have typically reflected negatively on forecast liquidity within the Avon group (i.e. the implication that pressure would grow upon Aquila's investments to upstream liquidity to the U.S. parent) and therefore strongly influenced the rating of AEPH. At the time, however, the risk of liquidity pressure was mitigated by a number of factors: the assets disposal was at an advanced stage of negotiation and due to be finalised by the end of 2002 and the estimated market value of the assets was sufficient to ensure assumption of or repayment of outstanding debt within the Avon group. Of comfort to creditors of APN was the fact that virtually all of the group's available liquidity was at the regulated entity level.

In January 2003 changes surrounding the regulatory intervention did not result in a re-rating since Fitch considered that debt servicing at subordinated levels within the Group was achievable going forward based on up-streamed cash flows arising from inter-company loans interest and principal repayments, and systematic purchases of tax losses, as agreed with Ofgem. Together with cash flow available at the intermediate holding company ME from associated and ancillary businesses, cash dividends would have provided for cash in excess of the coupon due on both the ME and AEPH debt, even in the absence of dividends from APN, pending conclusion of a sale.

RECENT DEVELOPMENTS

The sale of Avon has not, however, closed as anticipated, and the pool of European buyers interested in the asset base continues to shrink. As highlighted by Fitch in its special report dated 10 January 2003, delays in the sale process may be due, among other things, to the possibility that the prices bid were not consistent with Aquila's requirement for a cash equity return (i.e. a bid price which would return to Aquila an element of cash in addition to the assumption of Avon group debt). When Aquila bought its 79.9% of Avon in May 2002 from FirstEnergy Corp. (rated 'BBB' by Fitch) the price was partially paid in cash and the balance with a US$114m seller's note (now $95m) guaranteed by Aquila Inc. The latter amortises over six annual instalments, but would become payable in full upon the occurrence of a sale. It now seems clear that, in the context of Avon group consolidated net debt of GBP1.18bn, which excludes the seller's note payable to FirstEnergy, the offer currently on the table will not be sufficient to satisfy both shareholders and bondholders within the Avon group. While this may imply less pressure upon Aquila to dispose of AEPH, and thus crystallise a liquidity issue at the parent level, pressure on cash flows downstream from AEPH make a swift conclusion of the disposal an imperative for bondholders of AEPH. Additionally, under the (unlikely) scenario where a disposal were to be arranged even where a disposal price in excess of GBP1.18bn cannot be achieved, subordinated bondholders at Avon are exposed to a greater risk of default, and also a materially lower recovery rate than other parts of the Avon group. The Rating Watch Evolving reflects the uncertainty surrounding the outcome of the currently proposed sale - acquisition by a higher-rated entity combined with the paydown of existing debt may result in stabilisation of ratings or a rating upgrade for member companies within the Avon group; conversely, failure to complete an acquisition, or acquisition by a lower-rated entity may result in stabilisation of ratings or in a lowering of ratings.