By Megan Davies

The business to be spun out would also take in new investment from South African billionaire Johann Rupert, the source said. Lehman's bankruptcy estate will retain a substantial interest in the funds, the source said.

The proposed deal is subject to consent from the investors in the funds, known as limited partners.

A formal auction was run for the assets by Lazard on behalf of Alvarez & Marsal, Lehman's restructuring advisors, the source said.

A number of private equity firms including Blackstone Group and Lexington Partners Inc. had previously expressed interest in the assets, the source said.

The price for the proposed deal was unclear. The funds have about $4.5 billion in assets -- which includes money invested and money still to be drawn down from the limited partners.

Lehman Brothers Holdings Inc filed for bankruptcy protection in mid-September after trying to finance too many risky assets with too little capital.

It has been selling various assets since then, including December's sale of its prized asset management unit Neuberger Berman to a team consisting of Neuberger's management.

The management from Lehman's merchant banking business leading the proposed deal are Charles Ayres and Daniel James, the source said.

Investors in the funds include the Pennsylvania Public School Employees' Retirement System, the New York City Retirement System and fund manager Caisse de depot et placement du Quebec, the source said.

(Reporting by Megan Davies; Editing by Bernard Orr)