OREANDA-NEWS. Fitch Ratings has placed UK-based Viridian Group Investments Limited's (VGIL) Long-term Issuer Default Rating (IDR) of 'BB-' on Rating Watch Negative (RWN).

The RWN reflects the prospective refinancing of Viridian Group Fundco II Limited's (VGFII) senior secured notes, and Viridian Group Limited's (VGL) and Viridian Power and Energy Holdings Limited's (VPEHL) super senior revolving credit facilities (RCFs), which we expect to be repaid in full. On resolving the RWN, we expect to downgrade the IDR to 'B+'.

Fitch has also assigned expected ratings of 'B+(EXP)'/'RR4' to VGFII's proposed senior secured notes and 'BB+(EXP)'/RR1' to VGL's and VPEHL's proposed super senior RCFs. These notes and RCFs will be issued for the refinancing exercise and include weaker proposed covenants compared with the existing capital structure. The assignment of the final ratings is contingent on the receipt of final documents conforming to information already reviewed.

If completed, the refinancing will increase VGIL's funds from operations (FFO)-adjusted net leverage to just under 5x initially and around 4.2x on average for FY15-FY18 (financial year end March), but will likely improve coverage to over 2x. Although we expect leverage to eventually improve towards our 'BB-' rating guideline of 4x by FYE17 due to positive free cash flow (FCF) generation, this is subject to investments in renewable assets, uncertainty of growth in customer energy supply and the trading environment for its power generation segment.

The 'BB' rating on VGFII's existing senior secured notes and 'BB+' ratings on VGL's and VPEHL's existing super senior secured RCFs are affirmed as these bonds are expected to be repaid if the refinancing goes ahead.

The proposed refinancing and notes issue proceeds will be used to redeem the existing senior secured notes (due 2017) and super senior RCFs (due 2016). Proceeds will also be used to pay down some of the subordinated shareholder loan, which is currently classified as an equity-like PIK instrument by Fitch, and is thus not included in debt-based metrics for the restricted group. In turn the proceeds from the repayment of the shareholder loan are expected to be used to part repay junior debt obligations outside the restricted group.

KEY RATING DRIVERS

High Forecast Leverage
Fitch expects VGIL's FFO-adjusted net leverage to peak at just under 5x in FY15, compared with 3.6x in FY14, before declining to around 4.0x in FY17. The immediate increase in leverage is due to the issue of senior secured notes to redeem the existing senior secured notes (due 2017), to part repay the non-restricted group's PIK and to fund refinancing costs. The deleveraging that we expect to follow will be supported by projected positive FCF after FY15. Fitch has assumed no dividends will be paid until the restricted payment clause of consolidated net debt/EBITDA of 3.5x is achieved.

Interest cover is forecast to improve to around 2.1x in FY15 from 1.8x in FY14 and remain above the current rating guideline of 2x. This is due to a lower forecast cost of debt compared with previous debt instruments.

Weak Business Risk Profile
While VGIL's ratings are supported by predictable earnings from its regulated and quasi-regulated activities, its business risk profile is offset by a light and concentrated asset base, potential regulatory risk and increasing competition in retail operations. Considering our business risk assessment, we view the expected leverage as a key rating constraint.

VGIL's regulated retail supply and power procurement businesses generated about 30% of EBITDA in FY14, although regulation for this sector is not comparable with that of transmission or distribution networks. VGIL's quasi-regulated earnings, which represented another 23% of EBITDA for FY14, are supported by capacity payments for its combined cycle gas turbine (CCGT) plants.

At the same time the business risk profile is restricted by its two CCGTs of limited generation size, which are currently operating at low or close to zero per cent constrained utilisation as a result of low spark spreads and their mid-to-low merit order. Fitch notes low downside risk in the generation segment given low utilisation levels and the support from the capacity payments. Regulatory risk stems from the changes that are being considered to the wholesale electricity trading market and capacity payment calculation. The retail operations are under pressure from increased market competition.

Varying Recovery Expectations
The proposed senior secured notes will be subordinated to the GBP225m super senior RCF, which constitutes a cash facility of up to GBP100m and a letter of credit facility. The notes will also be subordinated to a maximum GBP70m of hedging liabilities, which have first priority ranking over the security. The expected rating of the RCF is notched up three levels from the post-refinancing IDR, while the proposed senior secured bond is rated at the same level as the post-refinancing IDR, given average recovery prospects. The asset profile of VGIL is light and unique relative to other utilities, with mostly contractual revenue streams in place.

Weaker Covenant Package
VGIL's prospective bondholders benefit from share pledges and guarantees from restricted group companies, and from fixed and floating charges over certain assets. Bondholders also benefit from a limitation of indebtedness test with a fixed charge coverage of 2x and a senior secured leverage test of 4x, up from 3x in the previous notes, with a higher carve out totalling GBP50m. Viridian is also allowed by the bond documentation to make GBP70m of investments in renewable assets, which may be debt-funded. The company can exceed 4x debt incurrence by drawing on the prospective RCF or issuing senior unsecured notes.

LIQUIDITY AND DEBT STRUCTURE

Liquidity is adequate as following the refinancing debt maturities are expected to be extended to at least 2020. Liquidity is further supported by positive projected free cash flow (FCF) after FY15 and a fully undrawn RCF.

RATING SENSITIVITIES

The resolution of the RWN is contingent on the outcome of the refinancing exercise. The final ratings of the bonds are contingent on the proposed refinancing taking place and the final terms conforming with those already reviewed.

Positive: An upgrade of the current IDR is not expected. However, if expected FFO adjusted net leverage decreases below 4x on a sustained basis, this could be positive for the ratings.

Negative: The proposed refinancing when completed, plus a FFO-adjusted net leverage of above 4x, will likely lead to a downgrade of the IDR to 'B+'. At that IDR level, further weakening of expected FFO adjusted net leverage to above 5x on a sustained basis would be negative for the ratings.