Both, you and cuddlybacon are right. A long time ago, they worked under the assumption that the FS is case-sensitive, and all the games I installed back then had title-cased folder names. Gradually, Valve stopped caring about this, and my games stopped working. I had to go in and manually change some game folder names to lower-case. It then kept some small files under SteamApps and the downloaded games under steamapps. They have fixed that now. Now, I have both CONFIG and config in my Steam folder.
How would it work? By a combination of magic and "we can't be bothered; the users should figure out something".