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Work units can be organized into Physical Folders on disk inside the root folder associated to a specific category of objects (example: Actor-Mixer Hierarchy). This is especially useful when you have hundreds of work units and don't want to have them flat in the same folder.
Physical Folder and Virtual Folder are two very distinct entities. The physical folder represents an actual directory on disk, while the virtual folder is part of its containing work unit file. Both are used to organize content, but the physical folder is an ancestors of a work unit and the virtual folder is a descendant of a work unit.
Physical folders can be created directly inside the Project Explorer by using the contextual menu on other physical folder, or by using the Project Explorer toolbar button.
Physical folder can only contain other physical folders or work units files.