This isn't fact, but I heard once they are dynamic 2D fluids with great shaders. Makes sense, as LBP acts mostly in a 2D plane.
The cake FX in LBP2 are some of my favourites ever, although they might have been a different system (I'd guess a framebuffer of 2D particles - which nowadays, googles' liquidfun would be great at - to feel like metaballs)
Edit: this presentation mentions LBP's method and is from around the time:
Further edit: slide 56 in this:
The whole thing is crazy interesting too