Graphite encapsulated nanoparticles have numerous possible applications due to their novel properties and their ability to survive rugged environments. Evaporation of Fe, Ni, or Co with graphite in a hydrogen atmosphere results in graphite encapsulated nanoparticles found on the chamber walls. Similar experiments in helium lead to nanoparticles embedded in an amorphous carbon/fullerene matrix. Comparing the experimental results in helium and hydrogen, we propose a mechanism for the formation of encapsulated nanoparticles. The hydrogen arc produces polycyclic aromatic hydrocarbon (PAH) molecules, which can act as a precursor to the graphitic layers around the nanoparticles. Direct evidence for this mechanism is given by using pyrene (C16H10), a PAH molecule, as the only carbon source to form encapsulated nanoparticles.