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Can SharePoint groups be used for audience targeting or does it need to a different group type like, M365?

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No, SharePoint groups are not supported.

Link: https://support.microsoft.com/en-us/office/target-content-to-a-specific-audience-on-a-sharepoint-site-68113d1b-be99-4d4c-a61c-73b087f48a81

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