Emerging markets these days might seem inconsolable. Investors, big and small, are once again heading for the exits ? and this time, they may not come back for a while. But against mounting global anxiety, and despite seemingly thinning returns, a pocket of hopefulness remains among deeply entrenched sponsors like American International Group (AIG), one of the largest global insurance companies investing private equity in developing world infrastructure, and its principal fund manager, Emerging Markets Partnership (EMP).

Indeed, although many project finance private equity funds are shifting their focus closer to home in developed markets, AIG and EMP are still adamant about potential returns in emerging markets project finance.

Says one Washington-based analyst, ?AIG has a lot of patient money, thinks it has a privileged entrée into regions like China and believes that it is sufficiently knowledgeable about the region to spot incipient bubbles and crises.?

But there is also a feeling among AIG type investors that East Asia will be the growth area ? no matter what. Equally, relative to future prospects, ?prices might now be quite attractive, and they believe that they do in fact need to diversify away from a still overpriced and relatively shaky US market, especially with the dollar looking distinctly overvalued.?

The long tenor of investment required by projects is ideal for their target investors such as life companies and pension funds. These companies of course have long dated-liabilities which need to be matched by long dated assets. Despite the high degree of downside risk mitigation with project financing, infrastructure nonetheless provides a strong yield base to a lot of portfolios and is relatively stable. Hence, its appeal.

But as an industry, private equity investing in emerging market infrastructure is less than a decade old. And none of the funds have yet yielded exited investments that would allow for meaningful measures of performance.

Emerging Markets Partnership (EMP) kicked off formally in 1992, when Moeen Qureshi and Donald Roth set out to raise an emerging markets investment fund, armed with AIG's sponsorship and the initial impetus of Hank Greenberg, AIG's chairman. Qureshi, a former prime minister of Pakistan and second in command of the World Bank, and Roth, a former Merrill Lynch chairman and later World Bank treasurer, had the clout, expertise and backing to confidently break into what was until then uncharted territory.

Indeed, the firm pioneered private equity investment in emerging market infrastructure with its AIG Asia I infrastructure fund, swiftly raising and investing $1.1 billion. In its wake cropped up numerous duplicate funds through similar emerging markets boutiques, eagerly hoping to capitalize on what seemed to be a goldmine for direct investments ? indeed, the rush towards infrastructure investment was a direct bet on emerging market expansion.

But many emerging markets boutiques, including EMP, were hit hard by global economic crises. Funds were particularly bruised by the Asian crisis and the ensuing emerging-market turmoil dashed immediate hopes for exit strategies through IPOs ? clearly more hazardous to undertake in emerging than developed markets. Now, they are again bracing for similar difficulties.

Obvious political and currency risks have served to create a daunting scenario for the ambivalent or unseasoned investor. To be sure, such private equity investments are not for the faint-hearted.

A few years ago, most equity investors' annual returns on project finance deals typically ranged between 20% to 25%. In the aftermath of economic crises, average return estimates were slashed to mirror ravaged and teetering markets.

But EMP cautions on the valuation of its investments, particularly since it is working with emerging market countries with relatively illiquid capital markets. The total market value of its investments is not readily discernible, given that most of its investments are unlisted and there is no available measure of the ?market value' of the bulk of the fund's securities.

?Estimates on realized IRRs may be somewhat misleading, given that for all the funds, large portions of the securities remain unsold, and the realized returns represent only a small portion of each fund's portfolio,? says the firm.

Despite signs of recovery last year, the global economic slowdown this year, exacerbated by attacks in the US, will likely wound emerging markets in the short run, turning once attractive turf for direct investment into a treacherous terrain yet again. But EMP remains confident.

Says a London-based private equity analyst, ?infrastructure is notoriously difficult to do as private equity investors. It's best left to strategic investors ? that's the general logic. But especially in emerging markets, it's a highly political process. And if you have the experience and the political connections, as EMP certainly has, then you've got a massive head start.?

Having dug into Asia and Latin America, EMP over the last two years has moved into Central and Eastern Europe with $600 million European fund. It has also recently raised a $500 million AIG fund for Sub-Saharan Africa. Also in sights is a $1.5 billion fund sponsored by the Islamic Development Bank (IDB) for infrastructure projects exclusively in the Islamic world. The IDB Fund is looking to provide equity capital (targeted at $1 billion) and complementary finance facilities (targeted at $500 million) using Islamic financial instruments.

EMP now manages around $5 billion in assets, principally sponsored by AIG, and almost exclusively comprised of infrastructure investments. Their portfolio spans four continents and all traditional project finance sectors. They are the largest direct equity investors in emerging markets.

And with AIG's powerful backing, as well as substantial support from other notable investors such as GE Capital, the funds' basic strength seems assured. As such, funds like Asia II look well positioned, when possible, to acquire existing assets where project sponsors need to restructure or refinance deals, or where they lack equity capital.

The last word has yet to be delivered. Risks are once again mounting. But the patience and perspective of long term money ? in this case, a lot of it ? is likely to be as crucial in determining the funds' successes (or, for that matter, the future proliferation of similar funds) as any swell or trough in emerging market performance might be.

So what do the experts say? Taimur Ahmad talks to Moeen Qureshi, Chairman of EMP, and Hank Greenberg, Chairman and CEO of AIG.

PF: What triggered AIG's diversification into emerging market infrastructure?

Greenberg: It was on a trip to Manila a decade ago, after experiencing severe brownouts in the region, that I started to seriously consider investing in infrastructure. We have a particularly large business in Asia. Even though our life company had always invested long term, because we have to, it was apparent that the infrastructure needs were greater than any local funds could generate. I came back and thought about starting an infrastructure fund, and together with EMP, we established our first Asia I fund.

Of course, local insurance companies invest policy holder reserves which have to be long term. When writing life insurance, you have twenty or thirty year liabilities. You have to match that with long term investment. Clearly infrastructure is a good match.

Where we build infrastructure funds we may make a commitment from our company for typically 10% of the fund, and 90% of the fund is raised by third party funds. That can come from pension funds, and other institutional money. But this is long term money. These funds are by their very nature long term. When you make an investment in a project, it may be years before that project is complete. This is something well understood by each investor.

On the other hand, there is no question that the emerging markets cannot meet their infrastructure requirements through public sector alone. It is precisely the constraints in government budgets as well as the size of investments that need to be made in infrastructure and requires that the private sector will play a role of prominence. The proper role for the private sector is ownership and management of infrastructure and services. The proper role for the government is trying to have an equitable environment for the investor and the consumer ? that means regulation, but not regulation at the expense of the investor or the consumer, but an equitable one.

PF: Why are you so confident about returns in markets that seem to be scaring off some of the more stalwart investors?

Greenberg: Clearly, the world economy is not great right now. But you have to look beyond that. The world economy is not going to stay in a slump endlessly. No emerging country can grow unless it has roads, power, water, and all the basic infrastructure to move up the economic ladder. We have to have funds that will pay at least the rate of returns that we invested. It's a long-term view, but I think its necessary. The private sector must be a catalyst for its development ? and I continue to believe that.

Private investors are pulling out of many investments these days. They're pulling out of developed markets as well as emerging markets. As we've seen, particularly recently, stock markets are highly volatile. One has to believe ? or at least I do ? that emerging markets are not going to stay in economic doldrums endlessly. Emerging markets will continue to be an area of opportunity. Given, for example, the cheap labor and the various innovative products coming out of these markets, that will continue.

Of course, you have to have an investment climate that is attractive, laws and regulations that can be relied upon and corporate governance rules that are appropriate. You have to have governments cooperate and understand that if you're going to have infrastructure funds they have to have a returns on investment that are attractive to foreign investment in the first place.

But I am very confident about our prospects. Although I can't predict the outcome right now, our Asia II fund and our Latin America funds look very favorable and I don't think they'll disappoint investors. After all, these are long term investments. The funds don't mature right away. And if markets are not attractive, we won't sell right away. But you need patient money and that's precisely what we have.

Qureshi: Over the past few years, it is clear that stock market returns in emerging markets have significantly under performed developed country stock markets. In the long-term, however, higher economic growth in the emerging markets will be recognized by the global equity markets, and rewarded.

The reality is that if we look at the last twenty years, real GDP growth in the emerging markets has significantly exceeded that in the developed economies. For the last 10 years, annual GDP growth in the US, European Union and Japan was 2.9%, versus 5.5% in developing countries, whereas in the prior 10 years annual GDP grew by 4.7% in developing countries, and 3.3% in the US, European Union and Japan.

At the moment, stock markets in many of the emerging markets countries are excessively depressed. While they may not rebound tomorrow or the next day, over time the great probability is that the economic growth in the developing countries will create profits for firms there, and the markets will value these profits. Asian markets in particular, have the potential to rebound strongly as growth gradually returns to the region after the Asian crisis.

Part of the rebound will come as market perceptions of the political risk inherent in several of the emerging markets are reduced. For example, as many of the central European countries accede into the European Union over the next few years, it is highly likely that the perception of them will improve, leading to an increase of capital into those markets and an increase in valuations. It is quite possible that we will see a similar phenomenon with several of the Latin American states, including Mexico and Brazil, as they continue to open up their economies to wider regional and international trade and investment.

PF: What are you doing to mitigate risks which other long-term investors consider too bulky?

Qureshi: First, we are selective in terms of country and sector exposure. While we have not always been right, we have focused our investments in countries and sectors where we believed the risk-reward was attractive, while still maintaining appropriate diversification. In Asia, this has meant a focus on China, Korea and India, while in Latin America, our investments are concentrated in Brazil and Mexico.

There are several other ways we reduce risks in our investments. Where possible, we have used structures such as convertible debt to increase our downside protection. We also usually invest with strong local partners who know how to work in the domestic business environment, coupled with strong international partners who are able to bring technical sophistication and additional capital if necessary. Because the size of our investments allows us to take significant minority positions in companies, we generally ask for a seat on the Board to monitor the investment, and add value when possible.

In many of the infrastructure sectors we invest in, we are able to structure protections from the impact of inflation and foreign exchange adjustments and inconvertibility. How this is done will depend upon the sector we are investing in: in power through long-term purchase and sale agreements; in toll roads, through rate reset arrangements that fluctuate with inflation.

Finally, the lack of liquidity in emerging markets means that it is important to structure mechanisms into our investments that increase our ability to sell them. We have used a variety of mechanisms including various bond structures, obtaining puts that enable us to sell our shares to other investors, in addition to obtaining commitments from the companies in which we invest to seek an IPO or sale over the medium to long-term.

PF: Having invested at the top of the cycle with the Asia I fund, returns were particularly affected by the subsequent Asia crisis. How has your strategy shifted to account for such volatility?

Qureshi: Volatility will be an unavoidable part of any private equity activity, whether in industrialized countries or in emerging markets. Of course, there will be greater volatility in emerging markets, because of the nature of their economies, and their role within the globalized financial system. The best strategy requires making investments, or buying assets, when things are depressed, since asset values are then attractive. Then you exit out when you're at the top of the cycle, when everything is buoyant. So the issue is one of adopting a strategy in which you take account of such cyclicality. That is the optimal strategy, but it's also a strategy that runs counter to human psychology. It's therefore very difficult to raise money from investors when things are depressed, even though it's the best time to invest.

Nevertheless, if your performance is good and if your investors have faith in you, they begin to understand that, and they're prepared to take that kind of risk. But you have to be extremely careful. I'm not suggesting that you should go and invest very liberally when times are bad. It's a time for very selective and careful decisions. Of course, there's no point in buying an asset if the cash-flow is non-existent, because it may not survive the downturn. You have to make very careful decisions ? and, at the same time, you have to be able to move quickly when the opportunity presents itself.

Our first Asia fund was greatly impacted by the systemic disturbances in Indonesia. Our investments in Thailand and the Philippines were also badly affected. But with our second Asia fund we were able to get in at very low asset values. Our timing was much better and now we can hope to perform much better.

Driving this understanding is a necessarily long-term perspective. At the same time, there must be an appreciation of the economic circumstances which inform such cyclicality.

Qureshi: If you're going to be in the private equity business, particularly as direct investors, then you have to have a long-term view. It is apparent that cyclical ups and downs are a inevitable part of working in an environment in which there is greater volatility, and hence greater risk ? but also greater rewards.

The recent downturn in the emerging markets has extended much longer than we had anticipated. But this is also a global phenomenon ? it is affecting all markets. Nevertheless, I'm confident that the turnaround will be even sharper in the emerging markets than it will be in the industrialized countries, because the very factors that depress or dampen the emerging markets are also the same factors that are likely to lend additional momentum to recovery when it takes place.

The Asian crisis didn't happen because there was a radical change in the economic fundamentals of those countries affected ? they had been performing strongly for almost three decades. Surely, something had been done right over those three decades for such phenomenal growth to occur. I'm quite confident that the recovery in the emerging markets will be just as strong as before.

PF: What role should multilateral institutions play? And what in particular can the private sector achieve that the multilaterals can't?

Qureshi: Multilaterals have a very important role to play, essentially in acting as catalysts and in trying to reduce the risk perception of potential investors. But ultimately their contribution in purely financial terms is minimal, albeit very effective. The whole process of decision making in multilateral institutions is necessarily slow. If you wish to move rapidly in the private sector, to capture the opportunities that arise, you have to be very nimble. Timing is most important. And private sector firms can often act with the kind of speed that the multilaterals by their very nature cannot.

I am extremely conscious of the fact that these institutions have a very constructive role to play, and therefore I look upon them as allies in what we're trying to achieve, rather than as competitors. There are broader areas where we and, for example, the IFC can collaborate, as we have indeed collaborated in recent years.

PF: How else do you expect global disturbances to impact the returns of each fund?

Qureshi: Global disturbances, depending upon their nature, can significantly affect the returns of fund investments. They can do so by influencing either the ?cost? or the ?revenue? streams of the investment.

The Asian crisis of 1997 resulted in a significant increase in interest rates and in a major depreciation of exchange rates of the affected countries creating a serious liquidity crisis for most enterprises. Similarly, a broad decline in stock markets can affect the exit prospects of Fund investments. The preferred route of exit for many investments is an IPO and deteriorating security markets can either delay the exit and/or affect their market valuation. Of course, the impact varies from investment to investment and, in some cases, can even be favorable.

In the case of most infrastructure projects, especially in power and transportation, the off-take of their products or services is governed by contractual arrangements which shield them, to some extent, from market volatility. For example, projects such as the production of methanol or of urea, which usually have fixed energy costs based on contractual agreements, can find their margins and profitability enhanced in the event of a global energy crisis.

For some of our investments, for example in Brazil, we thought we had an IRR of roughly 35%-40% at the beginning of this year. Since then, the Brazilian currency has depreciated and short-term economic growth forecasts have been reduced. So suddenly our IRR is down to 20%. It makes that much difference. So a project that was doing only 20% is now just going to break even. That's symptomatic of the volatility that we're facing. Of course, if I'm forced to sell, then I have a problem. But if, as an investor, I can wait, then as the currency improves and appetite returns, I'll make favorable capital gains.

In this business, you have to have a long term perspective. You have to be able to ride out these cyclical waves. And moreover, you have to be able to ride out some of these associated changes that affect the market. And if you ride them out, if you've structured your strategy and you've taken the steps to mitigate risks to be able to withstand their short-term disruptive impact, then you'll be rewarded.

PF: Do you think this is an understanding that will gain momentum among financiers and investors, despite the fact that so many sponsors are pulling out of emerging markets?

Qureshi: Many people will continue to have short-term perspectives, and will continue to perceive volatility when it comes to emerging markets. It is somewhat frustrating to see that many people, especially those who work in the field of finance, who should know better, have very short term views. They begin to cry wolf when things are depressed. And they forget about the nature of these cycles. Then, when the recovery comes, there is so much euphoria, which, in context, is unreasonable.

But there will also be more people entering the private equity business with long-term perspectives ? that is, with funds that don't mature in less than ten years. More people will see the profit opportunity, recognizing that returns in the longer term in emerging markets are going to be higher than returns in developed markets. That recognition will definitely gain momentum, despite there always being many people who are focussed on what happens in the stock market from day to day.

PF: What plans do you have for future expansion?

Qureshi: Obviously we believe that we have to continue to grow but we have to be sensitive to changes in the markets and in the economic environment. We are trying to look into some new areas which will be attractive in the present setting to some of our investors as well as in terms of what we feel is likely to yield attractive returns in the long-term.

Our primary focus will remain infrastructure. Even though we call our funds infrastructure funds and our primary focus has been infrastructure, the definition of areas where we can invest is very broad. We have invested in all kinds of natural resource development ? energy, etc, as well as large infrastructure related industries ? cement, paper, major capital intensive industries. That will remain our focus.

One of the areas we would like to work with going forward is the fixed-income sector. We know the emerging markets. We know the markets well and we are looking at some interesting possibilities ? particular areas of the fixed-income market ? that show strong potential for growth.

There is also room for some innovation. I believe at the moment that there is a great need for having some credit enhancement facilities that could enhance the credit of firms in these countries so that they can access capital markets. We'd like to help in this endeavor. It cannot be achieved without some support at the government level or through multilateral assistance. But if some multilaterals or other official sources become cognizant of this need, which I believe they are beginning to do, then we may together look at possible approaches more closely.

PF: What is your overall assessment of emerging markets, going forward?

Qureshi: In the short run emerging markets, can experience a great deal of volatility. In the recent past, a major reason for this has been the global integration of capital markets. Since capital markets in the emerging countries are much less developed and have much less volume and depth than the markets in the industrialized countries, any movements in the latter tend to get magnified in the emerging countries.

Over the long term however, the fundamentals of more rapid growth in the emerging markets, as compared to the industrialized countries, are bound to be reflected in higher returns on emerging market investments.

Our Funds, which have a 10-year horizon and a focus on infrastructure projects ? where the market risks are somewhat diminished ? have the ability to ride out short-term fluctuations and offer an excellent prospect of attractive returns to our investors, after taking account of a higher risk premium.