The rising tide of M&A and private equity deals in Europe threatens to undermine credit quality among companies in the region over the next 12 months, suggests a new report from Standard & Poor’s Ratings Services.

Credit rating downgrades are expected to increase among industrial companies from the low levels of the last two years, and are likely to significantly outstrip rating upgrades, S&P warns. Nevertheless, with economic conditions remaining relatively benign, the rating agency says that it believes defaults will stay low in 2006, before picking up in 2007.

S&P’s analysis of rated western European companies indicates that overall credit quality for industrials, banks, and insurers weakened slightly in the year to Nov. 30, with 142 downgrades against 116 upgrades–the ratio of 1.2 downgrades to every upgrade, little changed from that in 2004.

That said, the picture varies markedly between rated entities in financial services and industrials, and between those domiciled in Western Europe and Eastern Europe, Middle East, and Africa, it points out. Credit quality continued to improve materially in 2005 for financial services firms after an already strong 2004, S&P say. “European banks saw upgrades exceeding downgrades by 39 to 27, while insurance companies were relatively stable with 34 downgrades and 30 upgrades. On the other hand, the financial strength of rated industrial companies deteriorated, with 1.7 downgrades for every upgrade in 2005, against a ratio of 1.3 in 2004.”

“The biggest risk for creditors is the continuing abundance of liquidity from private equity firms and hedge funds, which we expect to persist well into 2006, given recent heavy fundraising by buyout investors,” S&P adds. “Debt leverage in buyouts has reached record levels, surpassing the peaks of the 1990s and suggesting bubble-like conditions in this market. Additionally, covenant structures, which should provide creditors with increased security, have weakened.”