Thames Water has suffered a major blow in its attempt to secure its future after US private equity giant KKR pulled out of a £4bn rescue deal for the company.

The setback increases the possibility that the UK’s biggest water company will collapse into a government-supervised administration.

Thames Water called the news “disappointing” but said it would proceed to work on an alternative plan, which is considered the last chance to save the company from administration.

Environment Secretary Steve Reed said the government was “carefully monitoring the situation”.

Thames Water serves about a quarter of the UK’s population, mostly across London and parts of southern England, and employs 8,000 people.

But it has huge debts and is struggling to fix leaks, stop sewage spills, and modernise outdated infrastructure.

Regardless of who owns Thames, its water services will continue as normal.

Thames Water is effectively owned by its lenders and a consortium of them has prepared a plan to raise equity which sources say is ready to go and fully funded.

In March, KKR had been selected by Thames as its preferred partner to inject £4bn of much-needed cash.

News of KKR’s withdrawal came on the same morning that an independent commission released interim findings of a review into how the water industry can be reformed – a review which many saw as potentially supportive in attracting new investment.

Sources close to the situation told the BBC that the politicisation of the water industry was a major disincentive for investors to put money into the sector.

Thames Water chairman Sir Adrian Montague said that while KKR’s withdrawal was “disappointing, we continue to believe that a sustainable recapitalisation of the company is in the best interests of all stakeholders and continue to work with our creditors and stakeholders to achieve that goal”.

“The company will therefore progress discussions on the senior creditors’ plan with Ofwat and other stakeholders.”

Castle Water, the UK’s largest independent water supplier to businesses, had previously expressed interest in Thames and on Tuesday said it was “ready and willing and able” to provide the company with financial support.

However, Thames insisted that it was only engaging with the plan from its creditors.

The chair of the Environment, Food and Rural Affairs Select Committee, Alistair Carmichael, said that when it quizzed Thames Water bosses in May, it had raised “serious concerns that Thames had only pursued one bidder at an early stage for its takeover bid, against the wishes of Ofwat, and highlighted the risks this could pose if KKR chose not to proceed”.

“Unfortunately, our concerns have been realised, putting Thames in a perilous position.”

The government has previously said it is ready to take over Thames Water in the event that it cannot continue to operate, but earlier this year the company secured a £3bn rescue loan to give it time to restructure.

Speaking in the Commons, the environment secretary said the government expected Thames to “fix the financial resilience of the company in the interests of their customers”.

However, he added the government “stands ready to intervene in the use of a Special Administration Regime should this be required to ensure the continued provision of vital public services”.

When Thames was privatised in 1989, it had no debt. But over the years it borrowed heavily and now has debts of about £19bn.

An interim report from an independent review of the water industry has said the water sector in England and Wales is failing and needs stronger regulation to better protect billpayers and the environment.

The review was chaired by Sir Jon Cunliffe, a former deputy governor of the Bank of England, who told the BBC the current regulatory system was “chaotic” and needed to change.

Sir Jon told the BBC’s Today programme that various regulators had competing remits which has made the “system incoherent and expensive”.

He said long-term investors were needed in the sector.

“People like pensions funds and insurance companies who take decisions for the long-term health of those companies,” Sir Jon said.

“If the water regulatory system is too volatile, too up and down, seeing the sort of problems we’re seeing at Thames, we won’t get those investors.”