Yes. You handle it openly and honestly. And maybe you use your connections to help the athlete find a different situation.
i have a personal experience with a family friend that really wanted to play a sport (not FB or Bball) at Illinois, but probably wasn’t quite good enough and it wasn’t a position of need. This person was invited to be a “preferred walk-on” but the Illini coach also recommended the athlete to a different school based on a coaching connection (I don’t want to say lower or lesser, but it wasn’t B1G) They got a full ride and had a great career.